Authors, Eleanor Banister, Atlanta, +1 404 572 4930, firstname.lastname@example.org and Ryan Gorman, Atlanta, +1 404 572 4609, email@example.com
Employees generally may not use contributions made to a health flexible spending account ("health FSA") in one plan year to purchase a benefit that will be provided in a subsequent plan year. This "use it or lose it" rule results in the forfeiture of unused balances remaining at the end of the plan year. Recently, the IRS announced an exception to the "use it or lose it rule," whereby employees may carry over up to $500 of a remaining health FSA balance for use in the following plan year. The carryover rule may be adopted effective as early as the 2013 plan year, but the carryover rule is subject to certain restrictions that may make it unattractive to some employers.
1. Health FSAs: Background
Health FSAs are offered under cafeteria plans pursuant to Section 125 of the Internal Revenue Code (the "Code"). Section 125 of the Code contains the origin of the "use it or lose it" rule, providing that a Section 125 cafeteria plan may not provide for deferred compensation.1 In 2005, the IRS softened its stance on the "Use It or Lose It" rule, permitting a grace period until March 15th of the following plan year in which to incur expenses under a FSA.2
In addition to the "use it or lose it" rule, health care reform imposes a $2,500 limit on employee contributions to a health FSA for plan years beginning after January 1, 2013.3 The IRS acknowledged that the $2,500 limit on FSA contributions "limits the potential using health FSAs to defer compensation and the extent to which salary reduction amounts may accumulate over time" and requested comments as to whether the "use it or lose it" rule should be modified.4 Public comments argued for additional flexibility.
2. IRS Notice 2013-71: The Carryover Option
To address public concerns over the lack of administrative flexibility, the IRS issued Notice 2013-71, which further modified the "use it or lose it" rule to permit up to $500 of the unused balance in a health FSA to be carried over to a subsequent plan year. The ability to carry over a portion of the unused health FSA balance is referred to as the "Carryover Option." Key rules regarding the Carryover Option are outlined below:5
No health FSA may utilize both the Carryover Option and a grace period. Thus, any employer whose health FSA currently utilizes a grace period must be amended to eliminate the grace period in connection with the implementation of the Carryover Option.
Unused health FSA balances may be applied to pay for expenses incurred in the plan year for which the contribution was made (if claimed during the plan's run-out period) or as a carryover to pay for expenses incurred at any time during a future plan year.
If John has an unused health FSA balance of $500 on December 31, 2013, he may use that balance in 2014 for qualified medical expenses incurred in 2013 (if his claim is made during the run-out period for 2013) or for qualified medical expenses incurred in 2014.
In determining the amount of the carryover, the employer must take into account expenses reimbursed during the health FSA's run-out period.
If Joan had an unused health FSA balance of $300 at the end of the 2013, but was reimbursed $100 during January 2014 (the run-out period) for 2013 expenses, she would have a carryover of $200 to apply to 2014 expenses.
The carryover does not reduce the $2,500 limit on health FSA contributions.
John's ability to make salary reduction contributions of up to $2,500 in 2014 is not affected by his carryover of $500 from 2013.
The carryover cannot exceed $500, but the plan may specify a lower maximum carryover amount.
Joan's employer, ABC Co. could amend its cafeteria plan document to provide that employees who have contributed to a health FSA have a maximum carryover of $250 instead of $500.
Amounts in excess of the carryover maximum will be forfeited at the end of the applicable plan year.
If John's employer permits a carryover of $500, but John has an unused balance of $750, only $500 will be carried over and the difference ($250) will be forfeited.
The carryover may be carried over in consecutive future years, regardless of whether the employee is making salary reduction contributions to the health FSA in those future years.
Joan has a carryover of $300 from 2013, and does not elect salary reduction contributions to the health FSA for 2014 or 2015. She incurs $100 of qualified medical expenses in 2014, which is reimbursed from the carryover. Joan will have a balance of $200 that is available to reimburse qualified medical expenses incurred in 2015.
3. How and When to Incorporate the Carryover Into Your Plan
A cafeteria plan offering the health FSA must be amended to incorporate the Carryover Option and delete any grace period. The deadline to adopt the amendment is the last day of the plan year from which amounts may be carried over. For example, if ABC Co. wishes to adopt the amendment for its calendar year plan so that participants can carryover amounts from 2013 to 2014, the amendment must be adopted on or before December 31, 2013. If ABC Co.'s plan contained a grace period prior to the amendment, the grace period for 2013 must be eliminated. Employers may find it difficult to eliminate a grace period for 2013 since employees made salary reduction elections for 2013 based on the fact that there would be a grace period in 2014 in which to use those contributions and may have scheduled medical procedures with that grace period in mind. Further, employers desiring to amend their plans for the 2014 year likely have already communicated the availability of a grace period for 2014. Such plan provisions and communications may give rise to rights under other laws, for example, ERISA or state law.
4. Carryover and Health Savings Accounts
High deductible health plans with health savings accounts ("HSAs") have become increasingly popular. However, two HSA rules limit the ability of an employee to have both a HSA and a FSA: (a) employees enrolled in general purpose health FSAs are ineligible to contribute to HSAs6, and (b) employees may not contribute to HSAs while they have a health FSA balance.7
IRS Notice 2013-71 is silent as to how the Carryover Option will affect the HSA rules mentioned above. A strict reading of the HSA rules suggests that individuals with a carryover from a general purpose health FSA would be ineligible to contribute to a HSA for the subsequent plan year (at least for the period in which the employee may access the carryover). Given the fact that the IRS released separate guidance regarding the effect of a FSA grace period on HSA contributions, many commentators expect the IRS to provide future guidance on how the Carryover Option will affect HSA contributions.
5. Transition Relief For Non-Calendar Year Plans
IRS Notice 2013-71 also clarifies previous transition guidance provided for non-calendar year plans for the year beginning in 2013.8 That transition guidance allowed applicable large employers to amend their non-calendar year plans to allow employees a one-time opportunity to prospectively change or revoke an election or to make a prospective election of salary reduction contributions in connection with an employer-provided accident and health plan. The transition rule would allow prospective changes that might be necessary to elect coverage on an exchange. The Notice clarifies that the transition relief is available to employers who are not "applicable large employers" and allows employers to limit the period during which such an election may be made.
Employers should exercise caution when considering whether to implement the Carryover Option, taking into account the possibility of increased administrative costs and the unavailability of a grace period. Further, the rules regarding the interaction between the Carryover Option and HSAs are far from clear at this point, so employers with HSAs will want to exercise additional caution. Further, employers will have to weigh the advantage of having the carryover amount available until utilized versus having the entire $2,500 (or lesser limit) available during the grace period. Nonetheless, the Carryover Option may be particularly attractive to employees with unused health FSA balances of $500 or less at the end of the plan year.
Employers wishing to allow carryovers from the 2013 plan year must amend their plan documents by the last day of the 2013 year. King & Spalding is happy to assist you with implementing the Carryover Option, as well as any other questions you may have regarding this new health savings opportunity.
1 See §125(d)(2) of the Code. See also Prop. Treas. Reg. §1.125-1(c)(ii)(7)(C).
2 See IRS Notice 2005-42. Note that a grace period is to be distinguished from a "run-out" period, which is a period following the plan year during which a participant can request reimbursements for qualified medical expenses incurred during the plan year.
3 See §125(i) of the Code, as amended by §10902 of the Patient Protection and Affordable Care Act.
4 See IRS Notice 2012-40.
5 For purposes of these examples, assume the cafeteria plan operates on a calendar year basis.
6 See Code §223(c)(1)(A)(ii). See also, Rev. Rul. 2004-45, Situation 1.
7 See Code §223(c)(1)(A)(ii). IRS Notice 2005-86 provides that employees with an unused health FSA balance may participate in a HSA after the health FSA grace period expires (i.e. if the grace period expires on March 15, the participant may contribute to the HSA on April 1st of the subsequent plan year).
8 Section IX.B of the preamble to proposed regulations relating to shared responsibility under Section 4980H provides the transition rule. See 78 Fed. Reg. 218, 237.