In 2005, the Treasury Department and the IRS pleasantly surprised cafeteria plan participants when they relaxed the strict "use-it-or-lose-it" rules for health flexible spending accounts (FSA) under Internal Revenue Code (Code) Section 125 by permitting grace periods. Eight years later, they have done it again. In recently issued Notice 2013-71
, the Treasury and IRS further eased the use-it-or-lose-it rules to allow up to $500 of unused health FSA amounts remaining at the end of a plan year to be "carried over" to the following plan year. These amounts can then be used to pay or reimburse plan participants for qualified medical expenses incurred during the following plan year.
The Section 125 regulations originally provided that any unused amounts remaining in a health or dependent care FSA after the end of the year were forfeited. That changed in 2005 when the grace period rules were adopted. Those rules permit a cafeteria plan to adopt a 2½ month grace period during which medical and dependent care expenses could be incurred and reimbursed up to 2½ months after the end of the year. More recently, the Patient Protection and Affordable Care Act of 2010 (PPACA) amended Code Section 125 to place a $2,500 limit on salary reduction contributions to health FSAs, beginning in 2013. Guidance regarding the $2,500 limit was released in Notice 2012-40, in which the Treasury Department and IRS requested public comments on whether additional flexibility should be given with regard to the use-it-or-lose-it rules for health FSAs. In direct response to these comments, Notice 2013-71 was issued providing for the $500 carryover option.
How It Works
Under the new rules, an employer may amend its cafeteria plan to allow participants to carry over to the next plan year unused amounts remaining in a health FSA at the end of the current plan year and use those amounts to pay or reimburse health FSA medical expenses incurred during the entire plan year to which it is carried over. The Notice clarifies that the amount remaining unused at the end of the plan year is the amount unused after medical expenses have been reimbursed at the end of the cafeteria plan's run-out period, if any, for the plan year (a run-out period is the period immediately following the end of a plan year during which a participant can submit a claim for reimbursement of expenses incurred during the plan year). For example, if a participant in a calendar year cafeteria plan had $500 remaining in his or her health FSA at the end of 2014 (or at the end of the run-out period), instead of being forfeited, that $500 would be carried over and available to pay claims incurred in 2015.
The maximum amount that may be carried over is $500; however, a plan may provide for a lower amount – or not to allow a carryover at all. Also, the $500 carryover amount is in addition to, and has no effect on, the $2,500 salary reduction limit applicable to each plan year. This means a participant could potentially have $3,000 available to pay for medical expenses incurred in a plan year (the $2,500 allowed for a current plan year and up to a $500 carryover from the prior plan year). The amount that may be carried over to the following plan year equals the lesser of: (i) any unused amounts from the immediately preceding plan year or (ii) $500 (or any lesser amount specified in the plan). Any unused amounts remaining at the end of the plan year greater than $500 (or lesser amount specified in the plan) are forfeited. Finally, as mentioned above, the carryover option does not affect the ability of a health FSA to use a run-out period (but does affect the ability of a health FSA to adopt a grace period, as discussed below).
Plan Amendment Required
The new carryover provision is optional and employers are not required to offer it. However, if an employer wishes to provide the option under its cafeteria plan, it must amend the cafeteria plan document to provide for the carryover. The amendment must be adopted on or before the last day of the plan year from which amounts may be carried over. The Notice provides that an amendment may be effective retroactively to the first day of the plan year if the cafeteria plan operates in accordance with the guidance in the Notice and notifies participants of the carryover provision. To adopt the carryover provision for a plan year beginning in 2013, a special rule applies permitting a cafeteria plan to be amended on or before the last day of the plan year that begins in 2014 (i.e., Dec. 31, 2014, for calendar year plans). The same carryover limit must apply to all plan participants and the plan may not allow unused health FSA amounts to be cashed out or converted to any other taxable or nontaxable benefit.
Effect on Grace Periods
Importantly, the carryover option is an alternative to the grace period rules; therefore, a cafeteria plan that adopts a carryover may not also provide for a grace period in the same plan year. For example, a calendar year plan that allows unused amounts from 2014 to be carried over to 2015 would not be allowed to have a grace period in 2015 (although it would be allowed to have had a grace period during the first 2½ months of 2014). If the plan has provided for a grace period and is being amended to add a carryover option, the plan must also be amended to remove the grace period by the end of the plan year from which amounts may be carried over (calendar year plans that currently have a grace period for 2013 but want to adopt a carryover provision for 2014 will need to be amended to eliminate the grace period by Dec. 31, 2013).
Potential Issues to Consider and Where More Guidance is Needed
Coordination with Run-Out-Periods. The carryover option must be administered differently depending on whether claims are submitted during a run-out period for the prior plan year or after the end of a run-out period. Due to these administrative complexities, employers who wish to allow carryovers for 2014 should ensure the new feature can be properly administered by their third party administrators by the beginning of the 2014 plan year.
Coordination with HSA Eligibility. For employers that provide high deductible health plans, the Notice is not clear on whether a participant with a carryover balance would be eligible to contribute to a health savings account. Further guidance is needed on this issue.
Treatment of Carryover Amounts When an FSA is Not Elected. The Notice includes an example of a carryover feature where an employee made an FSA election in 2014, but made no election for the 2015 or 2016 plan years. In the example, the employee carried over funds from 2014 that were available to him in 2015 and 2016 until they were depleted through qualified reimbursements. It is not clear whether an employer may design its carryover feature more restrictively, for example, to only allow carryovers to employees who make FSA elections for the current plan year. If this design were not permitted, an employer may have to monitor accounts of employees who have not participated in the health FSA for years, just because they did not exhaust their heath FSA when they did participate.
COBRA Issues. An employee who has any unused funds in his health FSA, including carryover amounts, at the time of termination would be able to elect COBRA continuation coverage with respect to the health FSA. There is some question as to how the employer would value the coverage for purposes of determining COBRA premium if all or a portion of the balance remaining in the employee's account at the time of termination reflects a carryover. More guidance from the IRS is needed on this issue.