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IRS Relaxes “Use-It-Or-Lose-It” Rule For Health Flexible Spending Arrangements

Notice 2013-71, 2013-47 IRB

Health FSAs are benefit plans established by employers to reimburse employees for health care expenses, such as deductibles and co-payments. They are usually funded by employees through salary reduction agreements, although employers may contribute as well. Qualifying contributions to and withdrawals from FSAs are tax-exempt.

Unused FSA contributions left over at the end of a plan year have historically been forfeited to the employer under the so-called “use-it-or-lose-it rule.” However, a plan can (but is not required to) provide an optional grace period immediately following the end of each plan year, extending the period for incurring expenses for qualified benefits to the 15th day of the third month after the end of the plan year (i.e., March 15th for a calendar-year plan). Benefits or contributions not used as of the end of the grace period are forfeited.

Under Code Sec. 125(j), which was added to the Code by the Affordable Care Act of 2010 (P.L. 111-148) and is effective for tax years beginning after December 31, 2012, in order for a health FSA to be a qualified benefit under a cafeteria plan, the maximum amount available for reimbursement of incurred medical expenses of an employee, the employee’s dependents, and any other eligible beneficiaries with respect to the employee, under the health FSA for a plan year (or other 12-month coverage period) cannot

exceed $2,500. The $2,500 limit will be indexed for cost-of-living adjustments for plan years beginning after December 31, 2013.

In Notice 2012-40, 2012-25 IRB 1046, IRS provided guidance on the effective date of the $2,500 limit on salary reduction contributions to health FSAs under Code Sec. 125(i), and on when and how plans should be amended to comply with the limit. IRS also requested comments on whether, in light of the $2,500 limit, the so-called “use-it-or-lose-it” rule should be modified.

According to Notice 2013-71, IRS received numerous comments in response to this request, with the “overwhelming majority” favoring modification of the rule. Among the reasons cited were difficulty in predicting future needs for medical expenses, the desirability of minimizing incentives for unnecessary spending at the end of a year or grace period, the possibility that lower- and moderate-paid employees are more reluctant than others to participate because of aversion to even modest forfeitures of their salary reduction contributions, and the opportunity to ease and potentially to simplify the administration of health FSAs.

So, in Notice 2013-71, IRS provided that an employer, at its option, can amend its Code Sec. 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 a 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. IRS further clarified that the up-to-$500 carryover doesn’t count against or otherwise affect the next year’s indexed $2,500 salary reduction limit, and that any unused amount in excess of $500 would be forfeited. IRS emphasized that the plan sponsor can specify a lower amount as the permissible maximum carryover amount, or can decide to not allow any carryover at all.

A plan adopting this carryover provision is not, for any plan year, permitted to allow an individual to put aside via salary reductions for qualified health FSA benefits more than the indexed $2,500 salary reduction limit, or reimburse claims incurred during the plan year that exceed the applicable indexed $2,500 salary reduction limit (plus the up-to-$500 carryover amount). If an employer amends its plan to adopt a carryover provision, the same carryover limit must apply to all plan participants. A Code Sec. 125 cafeteria plan is not permitted to allow unused amounts relating to a health FSA to be cashed out or converted to any other taxable or nontaxable benefit.

To utilize this new carryover option, a Code Sec. 125 cafeteria plan offering a health FSA must be amended to adopt a carryover provision on or before 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, provided that various requirements are met, including that participants are informed of the provision. The notice provided, however, 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.

A Code Sec. 125 cafeteria plan that incorporates a carryover provision may not also provide for a grace period in the plan year to which unused amounts may be carried over (i.e., the next year). Accordingly, if, pursuant to the carryover provision, a plan permits amounts that were unused in a plan year to be carried over to the following plan year, the plan is not permitted to provide for a grace period that occurs in that following plan year. 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. IRS cautioned that the ability to eliminate a grace period provision previously adopted for the plan year in which the amendment is adopted may be subject to non-Code legal constraints.

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IRS Circular 230 Disclosure: To the extent this message contains tax advice, the U.S. Treasury Department requires me to inform you that any such advice, whether in the body of the message or in any attachment, is not intended or written by my firm to be used, and cannot be used by any taxpayer, for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code. Advice from my firm relating to tax matters may not be used in promoting, marketing or recommending any entity, investment plan or arrangement to any taxpayer.

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