IRS Will Allow Some Unused Health FSA Funds To Be Carried Over To Entire Subsequent Years

In Notice 2013-71, the Internal Revenue Serivde has issued modifications to the Code Sec. 125 rules for cafeteria plans that include changes to the “use it or lose it” rule for health flexible spending arrangements (FSAs) currently set forth in proposed IRS regulations and clarification of the transition relief regarding changes in salary reduction elections for accident and health plans provided the preamble to proposed Code Sec. 4980H regulations.

Forfeiture rule modified to allow grace period. Qualified benefits as defined in Code Sec. 125(f) are generally not includable in an employee’s gross income and do not include certain qualified health plans offered through the exchanges, or marketplace, as established by the Patient Protection and Affordable Care Act (ACA). Proposed regulations that predate the ACA have prohibited participants from using health FSA contributions made for one plan year for benefits that are provided in a subsequent plan year. This “use it or lose it” rule requires forfeiture of any unused contributions that remain at the end of the plan year. The use it or lose it rule was modified in 2005 to allow for a grace period, whereby employees could use amounts remaining in their health FSAs from the previous year to pay certain expenses incurred up to two months and 15 days immediately following the end of the plan year (see IRS Notice 2005-42 and IRS Proposed Reg. Sec. 1.125-1(e)). To be qualified benefits, health FSAs must limit each employee’s salary reduction contribution to a maximum of $2,500 per plan year.

Carryover of $500 now allowed. Now, under the newly-issued guidance, the IRS is stating that employers have the option to amend their cafeteria plans to provide for the carryover of up to $500 in unused health FSA contributions to the immediately following, and, if the employer wishes, entire, plan year. The funds remaining unused, for the purpose of the IRS guidance, is the amount left after medical expenses have been reimbursed at the end of the plan’s “run-out” period, which is the period immediately following the end of a plan year during which participants can still submit reimbursement claims for expenses they incurred during the plan year. Employees may still elect up to the maximum allowed salary reduction ($2,500) for that immediately following year.

The IRS cautions that plans adopting the new carryover provision also may not provide the two-and-a-half month grace period, and they may not allow employees to salary reduce for health FSAs in excess of $2,500 per plan year plus the $500 carryover amount. The same carryover amount must apply to all plan participants, and unused health FSA amounts may only be used for medical expenses described in Code Sec. 213(d). Amounts remaining used that exceed $500 are to be forfeited, as is any unused amount remaining in an employee’s account when he or she is terminated, unless the employee elects COBRA continuation coverage with respect to his or he health FSA. Also, the uniform coverage rule, which requires that the maximum amount from the health FSA be available at all times for claims incurred during the coverage period, also applies to the $500 carryover amount.

The IRS explains that, under the carryover option, health FSA funds remaining in a participant’s account at the end of the plan year may be used either for expenses incurred in the prior plan year if they are claimed during the immediately following run-out period, or for expenses incurred (up to $500) at any time in the current plan year. For administrative convenience, plans may treat claims for expenses incurred in the current plan year as reimbursed first from the current plan year’s unused funds, and, when those are exhausted, as reimbursed from the preceding plan year’s unused funds.

To take advantage of the carryover option, plans must be amended, with the amendment being adopted on or before the last day of the plan year from which amounts may be carried over. The amendment may generally be effective retroactive to the first day of that plan year. Plans with grace periods being amended to add a carryover must eliminate their grace period provisions no later than the end of the plan year from which amounts may be carried over.

As an example of a Code Sec. 125 plan that satisfies the new IRS guidance, the IRS uses the following as an illustration:

An employer has a cafeteria plan and health FSA with a calendar plan year, an annual run-out period of January 1 through March 31, and an open enrollment period in November. Participants can elect a salary reduction amount up to $2,500 for the following plan year, and the plan is timely amended to add a carryover of up to $500. The plan does not allow a grace period or nonelective employer flex credits.

In November 2014, a participant elects a salary reduction of $2,500 for 2015, and has $800 in unused funds at the end of 2014. On February 1, 2015, he submits claims for expenses incurred in 2014 in the amount of $350, now leaving a carryover of $450 from 2014. The $450 is not forfeited, as it would have been in the past, and it is carried over to 2015, so that the participant will have $2,950 available to pay claims incurred in 2015. The participant submits $2,700 in claims in 2015, and is reimbursed for that amount, potentially leaving $250 as potential unused funds from 2015.

Transition rule for non-calendar year plans. The new guidance also contains clarification from the IRS of material in the preamble to Code Sec. 4980H proposed regulations, published Jan. 2, 2013. Normally, cafeteria plan elections cannot be changed during the plan year, except under limited circumstances, such as a change in status. As existing rules now stand, the availability of coverage via the marketplace is not such a change in status, so employees could not choose during a plan year to cease their salary reductions and purchase marketplace health coverage. For employees with non-calendar year cafeteria plans, coverage through the marketplace would first become available in the middle of the plan’s 2013-2014 plan year (in January 2014). Under transition relief contained in the January 2013 proposed regulations, employers may amend such cafeteria plans to allow for the following changes in salary reduction elections by an employee, regardless of whether or not the employee had an otherwise required change in status event:

1. An employee who elected a salary reduction for accident and health coverage through the employer’s cafeteria plan with a non-calendar plan year beginning in 2013 may prospectively revoke or change his or her election once during that plan year; and

2. An employee who failed to elect a salary reduction for accident and health coverage through his or her employer’s cafeteria plan with a non-calendar plan year beginning in 2013 before the requisite deadline set forth in IRS Proposed Reg. Sec. 1.125-2 may make a prospective salary reduction election for accident and health coverage on or after the first day of the cafeteria plan’s 2013 plan year.

The IRS adds that, although the transition rule, as described, refers to applicable large employers, the relief is generally available to employers with non-calendar year Code Sec. 125 cafeteria plans, even if they or not applicable large employers or applicable large employer members under Code Sec. 4980H. The IRS also clarifies that amendments to cafeteria plans pursuant to the above transition relief may be more restrictive than that described, but not less restrictive. These clarifications may be applied beginning on or after Dec. 28, 2012.

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