The IRS has modified the “use-or-lose” rule for health flexible spending arrangements (FSAs) to give employers the option to allow participating employees to carry over up to $500 of unused amounts remaining in their health FSAs at year-end. Previously, any amounts that weren’t used by year-end or the end of an optional “grace period” of up to 2Â½ months would be forfeited. Employers may be eligible to take advantage of this option as early as plan year 2013 if their plan is properly amended [Notice 2013-71, 10-31-13].
Why the change? The original “use-or-lose” rule was adopted to prevent employees from using a health FSA as a vehicle to defer compensation by accumulating salary reduction amounts. But when the $2,500 limit on salary reductions was enacted, the IRS said this limited the potential for such large accumulations. This, combined with the difficulty for employees of predicting their future medical expenses, the desire to minimize incentives for unnecessary spending at the end of the plan year or grace period, employees’ aversion to even minimal forfeitures of their salary reduction amounts, and the chance to ease health FSA administration, led the IRS to inject even more flexibility into the “use-or-lose” rule.
$500 carryover allowed. Under the new guidance, an employer can amend its cafeteria plan document to allow employees to carry over to the immediately following plan year up to $500 of any unused amount in a health FSA as of the end of the plan year. The carryover amount may be used to reimburse medical expenses incurred at any time during the plan year to which it is carried over.
No effect on $2,500 limit. The carryover doesn’t count against or otherwise affect the next year’s $2,500 salary reduction limit, as indexed for inflation, and any unused amount in excess of $500 will be forfeited under this modified “use-or-lose” rule.
Lower amount OK. The plan can specify an amount lower than $500 as the maximum carryover amount, or can decide not to allow any carryover at all. Whatever decision the employer makes, the plan must allow all employees to carry over the same maximum amount.
No grace period plus carryover. A cafeteria plan that is amended to include a carryover provision may not also include a grace period in the plan year to which unused amounts may be carried over (e.g., no grace period is allowed in 2015 if unused amounts can be carried over to 2015). If a plan with a grace period is being amended to add a carryover provision, the plan amendment must eliminate the grace period by no later than the end of the first plan year from which amounts may be carried over.
No cash-out of carryover amount. One rule has not changed. A cafeteria plan may not allow unused amounts in a health FSA to be cashed out or converted to any other taxable or nontaxable benefit.
Plan amendment needed. To take advantage of the carryover option for a plan year, the employer must amend its cafeteria plan to adopt a carryover provision on or before the last day of that plan year. If that is done, the amendment may be made effective retroactively to the first day of that plan year. However, the notice also provides that a plan may be amended to adopt the carryover provision 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.