Burton S. Speer, The Daily Record Newswire
As the end of the year approaches, many of us that have flexible spending plans still have funds that may need to be spent, or risk losing the benefits of having put part of our salary into the plan. Flexible Spending Arrangements may also be known as Flexible Spending Account, a Cafeteria Plan or simply a Section 125 plan (for the Internal Revenue Code Section allowing such plans).
A FSA is a written plan maintained by an employer under which employees may choose among two or more benefits consisting of cash and qualified benefits. Many medical FSAs include plans whereby employees make pre-tax contributions into the plan, and use the plan to pay for qualified benefits, which may include health insurance premiums and allowable health care costs, such as doctor and hospital costs, vision care, dental care and prescription medicine.
One of the rules of these plans is that they cannot provide for any type of deferred compensation. The IRS regulations prohibited employees from using contributions made for one plan year for a benefit that will be provided in a next plan year. This is commonly referred to as the “use it or lose it” rule. This rule requires that unused benefits or contributions remaining as of the end of the plan year in the employee’s health FSA account be forfeited.
As a result, many employees look for ways to spend these remaining funds on last-minute dental or vision exams, purchasing items such as new eyeglasses, prescription sunglasses or building up their supply of contact lenses, or ordering the next month’s prescriptions before year end. Even with these year-end expenditures, many employees still end up losing some of their benefits.
In 2005, the IRS modified the “use it or lose it” rules by adopting the grace period rule. Under the grace period rule, a FSA plan may permit an employee to use amounts remaining from the previous year’s FSA to pay qualified medical expenses paid by March 15 of the following year (for a calendar year plan). However, many employers still have not yet changed their FSA plans to allow for this grace period.
Section 125 was recently changed under the Patient Protection and Affordable Care Act. Beginning in 2013, employees are limited to a $2,500 maximum annual salary reduction contribution that can be made to their health FSA. After 2013 this limit will be indexed for cost-of-living adjustments.
In 2012, the IRS recognized that the new lower $2,500 maximum contribution significantly limits the potential for using health FSAs to defer income, and began considering whether the “use it or lose it” rule for health FSAs should be modified to provide a different form of relief. The IRS requested comments on whether the rules should be modified to provide flexibility with respect to the use-or-lose rule for health FSAs.
It was no surprise that the overwhelming majority of comments favored modification of the use-or-lose rule for a number of reasons. These included the difficulty for employees of predicting their future needs for medical expenditures, the desirability of minimizing incentives for unnecessary spending at the end of a year, and the possibility that lower- and moderately paid employees are more reluctant to participate in an FSA because of the risk of even modest forfeitures of their salary reduction contributions.
In response to the comments, the IRS determined that it would be appropriate to modify the use-or-lose rule to permit the use of up to $500 of unused amounts in a health FSA in the immediately following plan year.
Accordingly, an employer, at its option, is now permitted to amend its §125 cafeteria plan document to provide for the carryover to the immediately following plan year of up to $500 of any amount remaining unused as of the end of the plan year in an employee’s health FSA. The carryover of up to $500 may be used to pay or reimburse medical expenses under the health FSA incurred during the entire plan year to which it is carried over.
Although the maximum unused amount allowed to be carried over in any plan year is $500, the employer may use a lower amount as the allowable carryover, and of course has the option of not permitting any carryover at all. A plan adopting this carryover provision is not permitted to also provide a grace period with respect to health FSAs.
Therefore each employer should decide if they want their health FSA to have the up to $500 carryover, a grace period or neither. In addition, if an employer amends its plan to adopt a carryover, the same carryover limit must apply to all plan participants.
It is important to understand that this carryover of up to $500 does not count against the regular $2,500 salary reduction limit applicable to each plan year. Therefore, the plan may allow an individual to be reimbursed for claims incurred during year for up to the $2,500 salary reduction limit plus the carryover amount of up to $500.
To utilize this new carryover option, the health FSA must be amended. The amendment must be adopted by the last day of the plan year from which amounts may be carried over and may be effective retroactively to the first day of that plan year. There is a special one-time provision that will allow an employer to amend their health FSA plan to adopt these carryover provisions for a plan year that begins in 2013 at any time on or before the last day of the plan year that begins in 2014.
It needs to be noted that if a plan has provided for a grace period and is being amended to add a carryover provision, the plan must also be amended to eliminate the grace period provision by no later than the end of the plan year from which amounts may be carried over.
However, eliminating a grace period provision previously adopted for the plan year may be subject to certain legal constraints. The plan administrator should be sure to consult an expert before making such a change.
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Burton S. Speer is a partner in the tax department at Mengel, Metzger, Barr & Co. LLP, and can be reached at Bspeer@mmb-co.com or (585) 423-1860.
