IRS Modifies “Use-It-Or-Lose-It” Rule for Health Flexible Spending Arrangements under Cafeteria Plans

by Goodwin
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In Notice 2013-71 (the “Notice”) issued October 31, 2013, the IRS modified the so-called “use-it-or-lose-it” rule to allow up to $500 of unused amounts remaining in a health flexible spending arrangement (“HFSA”) at the end of a plan year to be carried forward and used for payment or reimbursement of qualified medical expenses incurred in the following plan year.  Employers who wish to take advantage of the new carryover rule must amend their plans and should notify employees within the time frames described below.

Background

Federal tax law permits employers to make HFSAs an option under their cafeteria plans (also known as “Section 125” plans).  If that option is made available, an employee may elect to contribute a designated amount – up to $2,500 – to the HFSA for a plan year on a pre-tax basis, and that amount may be used to pay or reimburse the employee for qualified medical expenses.  HFSAs may provide savings for employees as an employee can pay for qualified medical expenses using pre-tax, rather than after-tax, dollars. 

In general, medical expenses may be paid or reimbursed from amounts contributed to an HFSA during a plan year only if those expenses are incurred during that year.  Further, under the Use-It-Or-Lose-It Rule, amounts remaining in an HFSA at the end of a plan year generally must be forfeited by the employee – i.e., those amounts cannot be carried forward to the next plan year and used to pay or reimburse the employee for expenses incurred in that subsequent plan year.

In 2005, the IRS provided an exception to the Use-It-Or-Lose-It Rule by permitting cafeteria plans to provide that amounts contributed by an employee to an HFSA for a plan year could be used to pay or reimburse the employee for qualified medical expenses incurred during a period of up to 2½ months following the end of that plan year (the “Grace Period”).  Also, the IRS has recognized that an HFSA may provide for a period (the “Run-Out Period) following the end of the plan year (or, where applicable, the Grace Period) during which employees may file claims for payment or reimbursement of expenses that were incurred during the plan year in which the amounts were contributed (or during the relevant Grace Period where applicable).

Modification Provided by the Notice – the Carryover Rule

The Notice provides an additional exception to the Use-It-Or-Lose-It Rule.  Under the Notice, a cafeteria plan may provide that up to $500 remaining in an employee’s HFSA at the end of a plan year may be carried over to the following plan year and be used to pay or reimburse the employee for qualified medical expenses in that subsequent plan year (the “Carryover Rule”).

The amount carried over may be used to pay or reimburse qualified medical expenses incurred at any time during that following plan year.  Further, the amount carried over does not reduce or otherwise affect the amount that the employee may contribute to the HFSA during that following plan year.

An HFSA may use this new Carryover Rule exception only if several conditions are satisfied:

  • An HFSA may not use the Carryover Rule with respect to a plan year and also provide a Grace Period for that same plan year.  For example, an HFSA that has a calendar plan year could not permit amounts to be carried over from the plan year ending December 31, 2015 (“PY2015”) to the plan year beginning January 1, 2016 if that HFSA also provided a Grace Period for PY2015 (e.g., during the first 2½ months of 2016).
  • The maximum amount that may be carried over to a new plan year is equal to the lesser of (i) the unused amount from the immediately preceding plan year, and (ii) $500 (or any lower amount specified in the cafeteria plan/HFSA document).  Any unused amount from the immediately preceding plan year that exceeds this maximum must be forfeited.  (For this purpose, the unused amount is the amount remaining in the HFSA as of the end of the preceding plan year, after taking into account expenses incurred during that preceding plan year but paid or reimbursed during the Run-Out Period.)
  • An HFSA may provide for a carryover limit that is less than the maximum described above.  However, the same carryover limit must apply to all employees.

The Notice indicates that an HFSA that uses the Carryover Rule may treat payment or reimbursement of all expenses during the current plan year as being paid or reimbursed first from amounts credited for that current year, and that amount carried over from the prior year will be used to reimburse current year expenses only after the current year credits have been exhausted.  This may be important because, e.g., use of amounts carried over from the prior year to reimburse or pay current year expenses will reduce amounts available to pay or reimburse prior year expenses during the Run-Out Period.

Plan Amendments and Other Actions Needed to Take Advantage of the New Rule

Employers will need to include information regarding the carryover rule in open enrollment materials this fall (or amend enrollment materials that have already been distributed) if the employer wishes to take advantage of the new Carryover Rule for the plan year beginning in 2014.

The relevant cafeteria/HFSA document generally must be amended to provide for the Carryover Rule no later than the last day of the plan year from which amounts may be carried over (retroactive to the first day of that plan year); however an amendment adding the Carryover Rule for a plan year that begins in 2013 may be made at any time on or before the last day of the plan year that begins in 2014.  If the plan has provided for a Grace Period, it must be amended to eliminate the Grace Period no later than the end of the plan year from which amounts may be carried over.

For example, if an employer wishes to amend a plan to apply the Carryover Rule for the plan year ending December 31, 2014 (i.e., so amounts may be carried over into the 2015 plan year) and that plan provides for a Grace Period, the plan must be amended no later than December 31, 2014 to eliminate the Grace Period (so that there would be no Grace Period at the beginning of 2015 applicable to 2014 contributions). However, attempting to eliminate the Grace Period for a plan year that has already begun may present employee relations issues or legal issues beyond those addressed by the Notice.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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