November 14, 2013
New Rules for Health FSAs and Cafeteria Plans
On October 31, 2013, the Treasury Department and the Internal Revenue Service (IRS) announced a modification to the longstanding “use-it-or-lose-it” rule applicable to health Flexible Spending Arrangements (FSAs). Under that rule, employees who do not use the entire balance of their health FSA by the end of the plan year (or by the end of any applicable grace period) must forfeit any remaining amounts. The new modification permits employers to amend their cafeteria plans to allow employees to carry over up to $500 for use during the next plan year. The new guidance is published in Treasury Notice 2013-71.1
This Capital Checkup discusses the change to the use-it-or-lose-it rule, as well as other health FSA and cafeteria-plan requirements (Another issue of Sibson Consulting’s Capital Checkup reviews other requirements and options for FSAs and cafeteria plans introduced by the Affordable Care Act.2)
Background on Use-It-Or-Lose-It Rule and Grace Periods
The use-it-or-lose-it rule requires that employees either use the entire balance of their health FSA by the end of the plan year or forfeit the balance.3 Expenses must be incurred before the end of the plan year, but employees may submit those expenses during a run-out period after the end of the plan year. In 2005, Treasury and IRS published Notice 2005-42, which relaxed FSA rules to allow a grace period of up to two months and 15 days in the following plan year.4 Expenses incurred during the grace period could be submitted for reimbursement during the grace period or any additional run-out period allowed by the plan. Many employers adopted the grace period as a way to lessen the possibility that employees would forfeit money in a health FSA at the end of the year.
Notice 2013-71 and the Use-It-Or-Lose-It Rule
Notice 2013-71 gives an employer the option to amend its Section 125 cafeteria plan document to provide for the carryover to the following plan year of up to $500 of any amount remaining unused as of the end of the plan year in a health FSA. Employers that allow a carryover can select the amount, provided that it does not exceed $500. The same carryover limit must apply to all employees. The carryover does not count against the $2,500 maximum salary-reduction amount for the following plan year.
If an employer makes this carryover option available to its employees, the employer will not also be able to offer a grace period and will have to eliminate any existing grace period under the plan. Consequently, employers may either permit a carryover of up to $500 or operate a grace period, but not both. In addition, both the carryover and grace period are voluntary — employers may decide that neither option is appropriate for their plan.
Notice 2013-71 contains several examples of how reimbursements would be made under the carryover, if adopted by an employer. For example, the Notice gives the example of an employee with an unused health FSA balance in 2014 of $800. On February 1, 2015, the employee submits claims and is reimbursed with respect to $350 of expenses incurred during the 2014 plan year, leaving a carryover on March 31, 2015 (the end of the employer’s run-out period) of $450 of unused health FSA amounts from 2014. The $450 amount is not forfeited; instead, it is carried over to 2015 and available to pay claims incurred in that year so that $2,950 ($2,500 + $450) is available to pay claims incurred in 2015.
Examples in Notice 2013-71 make it clear that once the amounts are carried over, they may continue to be carried forward in subsequent years. For example, an employee with a $500 carryover from 2014 into 2015 who has no health expenses, and makes no election to contribute to the FSA in 2015, could still access the $500 carryover in 2016.
When administering the carryover, Notice 2013-71 requires that the plan treat reimbursements of all claims for expenses that are incurred in the current plan year as reimbursed first from unused amounts credited for the current plan year and, only after exhausting these current plan year amounts, as then reimbursed from unused amounts carried over from the preceding plan year. For example, suppose a plan permits an employee to carryover $500 from his or her 2014 FSA to 2015, and the employee has the full $500 remaining on January 1, 2015. This particular employee elects to make a salary-reduction contribution of $1,000 for 2015. The employee incurs a claim of $1,200 in February 2015. The claim would be reimbursed first with the $1,000 in the FSA for 2015, and then the remaining $200 would come from the carryover.
Written Cafeteria-Plan Amendments
Employers that choose to take advantage of the additional flexibility offered by Notice 2013-71 must amend their §125 cafeteria plans. In general, such an amendment must be adopted on or before the last day of the plan year from which amounts may be carried over. However, a special rule applies to employers that wish to allow carryover from any plan year beginning in 2013: the employer has until the last day of the plan year that begins in 2014 to amend the cafeteria plan document. In order to take advantage of this extension, the plan must be operated in accordance with Notice 2013-71 and employees must receive notice of the change.
For example, an employer may currently have a grace period, but wishes to change to the carryover. This employer would have to provide its employees with notice of the change. In addition, if the employer has a calendar-year plan, the employer would have to amend the §125 plan document to remove the grace period by no later than December 31, 2013. The employer could wait to amend the plan to add the carryover until December 31, 2014, but in reality both amendments could be accomplished at once.
Employers that do not currently use a grace period could wait until December 31, 2014 to add the carryover to the §125 plan document, but they could proceed to administer the plan with the carryover effective January 1, 2014 as long as employees have notice of the change and the plan is administered in accordance with Notice 2013-71.
Implications for Employers
Employers choosing between the grace period and the carryover may be uncertain which is more appropriate. Perhaps the greatest difference is that the grace period is limited to only 2 ½ months (although not limited to amount), whereas the carryover can extend throughout the entire plan year, but is limited in amount to only $500. In light of the fact that guidance was issued very late in 2013, and most employers have already made plans for open enrollment, it may be appropriate to take time to review the pros and cons of the two options prior to making any decisions.
Employers that offer Health Savings Accounts (HSAs) should ensure that they review any implications of an added carryover on the HSA offering, because employees eligible for certain types of FSAs would not be able to contribute to an HSA.
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As with all issues involving the interpretation or application of laws and regulations, plan sponsors should rely on their legal counsel for authoritative advice on the interpretation and application of the Affordable Care Act and related guidance, including the new guidance summarized in this Capital Checkup. Sibson Consulting can be retained to work with employers and their attorneys on compliance issues.
- Treasury Notice 2013-71 is on the IRS website. (Return to the Capital Checkup.)
- The Affordable Care Act is the shorthand name for the Patient Protection and Affordable Care Act (PPACA), Public Law No. 111-48, as modified by the subsequently enacted Health Care and Education Reconciliation Act (HCERA), Public Law No. 111-152. (Return to the Capital Checkup.)
- Forfeiture is not required when the employee elects continuation coverage under the Consolidated Omnibus Budget Reconciliation Act (COBRA) with respect to the health FSA. (Return to the Capital Checkup.)
- For more information about the grace period rules, see Sibson’s June 2005 Bulletin, “‘Use-it-or-Lose-It’ Rule for FSAs Is Relaxed Slightly.” (Return to the Capital Checkup.)
Capital Checkup is Sibson Consulting's periodic electronic newsletter summarizing activity in Washington with respect to health care and related subjects. Capital Checkup is for informational purposes only and should not be construed as legal advice. It is not intended to provide guidance on current laws or pending legislation. On all issues involving the interpretation or application of laws and regulations, plan sponsors should rely on their attorneys for legal advice.