Many employers offer health flexible spending account arrangements ("Health FSAs") through cafeteria plans to their employees. Historically, Health FSAs have been subject to a "use it or lose it" requirement, meaning that any unused amounts in a Health FSA at the conclusion of a plan year or at the conclusion of a grace period (if any) must be forfeited by the employee.
The "use it or lose it" rule remains in force, but has been modified by guidance issued by the Internal Revenue Service ("IRS") on October 31, 2013. Through IRS Notice 2013-71, the IRS permits plan sponsors to allow up to $500 of unused participant account balances to be carried forward to reimburse the participant for the next following plan year's eligible medical expenses. Internal Revenue Code Section 125 cafeteria plans can offer this new feature as early as the 2013 plan year.
In general, this Notice is viewed within the employee benefits community as a positive development. After all, employees routinely cite the "use it or lose it" forfeiture threat as one of the largest barriers to Health FSA participation. Any relaxation of that rule would seemingly be well received by employer and employee populations, and could increase the number of employees receiving the tax advantages afforded by Health FSAs.
That said, there are a few obvious traps for the unwary, and careful planning by employers is necessary prior to embracing this carryover feature:
Amendments Required. Cafeteria plan documents must be amended to permit this change. In general, the amendment must be adopted by the last day of the plan year from which amounts can be carried over. For example, a calendar-year employer wishing to allow its Health FSA participants to carry forward $500 of any remaining 2014 Health FSA balances into 2015 must amend its cafeteria plan by December 31, 2014.
Impossible to Offer with Grace Period. Prior IRS guidance had permitted Health FSAs to elect to provide for a 2 ½ month "grace period" after the end of the plan year, during which additional eligible expenses could be reimbursed from the previous year's contributions. A Health FSA may now have EITHER a grace period OR a carryover feature, but not both.
Interaction with Consumer-Driven Health Care. Special care must be exercised by employers separately offering high deductible health plans with health savings accounts (HSAs). While not addressed in the recent IRS Notice, it is expected that existing IRS rules regarding HSA contributions will apply to this new carryover feature. Under these rules, individuals could find themselves ineligible to make HSA contributions simply by being eligible to access Health FSA carryover funds from the previous year.