The Benefits Game: New Carryover Option for Health Flexible Spending Accounts – A Change in The “Use It or Lose It Rule”

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Summary

Some cafeteria plans already contain optional grace period provisions that modify the strict “use it or lose it” rules for Health Flexible Spending Accounts (“Health FSA” or “FSA”). These grace period provisions permit FSA participants to use any amount remaining in their FSA accounts at the end of a plan year to reimburse qualified medical expenses that are actually incurred during the first 2-1/2 months immediately following the end of that plan year. Employers can now provide another option that avoids the “use it or lose it” rule – a carryover option.

On October 31, 2013, the IRS announced in Notice 2013-71 (“ Notice”) [http://www.irs.gov/pub/irs-drop/n-13-71.pdf] a modification of the “use it or lose it rules” for Health Flexible Spending Accounts (“Health FSA” or “FSA”). The guidance permits an employer to amend its cafeteria plan to allow up to $500 of the amount unused under a Health FSA as of the end of the plan year to be carried over to pay for expenses incurred in the next plan year. The amount “unused as of the end of the plan year” means the balance remaining as of the end of the claim run-out period for the plan year (“run-out period”). A plan’s run-out period is a short period of time within the subsequent plan year when participants can submit for payment claims incurred during the prior plan year. While the maximum carryover amount is $500, a cafeteria plan can be amended to specify a lower Health FSA carryover amount so long as the same carryover amount applies to all Health FSA participants.Utilizing the optional carryover rule will not affect the maximum amount that the participant is otherwise permitted to contribute to the FSA for a year ($2,500, as may be adjusted by government guidelines). Thus, the carryover of up to $500 does not count against the maximum Health FSA salary reduction limit. So, a participant having a $500 carryover from one plan year (for example, from 2014) electing to contribute $2,500 for 2015, would have $3,000 available to pay for expenses incurred in 2015.

The law requires that the maximum reimbursable amount under a Health FSA be available for claims incurred at any time during the plan year (reduced as of any particular time for prior reimbursements). This is referred to as the uniform coverage rule and it continues to apply to plans that implement a carryover.

Ostensibly, in order to satisfy the uniform coverage rule, the guidance does not require a plan to wait until the end of the run out period for one plan year in order to carryover amounts for use against expenses incurred in the following year. Instead, plans can use FSA amounts remaining as of the last day of the plan year (e.g., amounts remaining on December 31, 2014 for a calendar year plan) as either carryover amounts to pay 2015 expenses or as amounts available to pay 2014 expenses submitted during the 2014 run-out period. However, any amounts that are used as a carryover to pay 2015 expenses then reduce the amount available to pay 2014 expenses submitted during the 2014 claim run out period.

Here is an example adapted from the Notice. Assume $800 remained as of December 31, 2014 in a participant’s Health FSA and the plan allows a $500 carryover. Assume also that the participant elected to contribute $2,500 to the Health FSA for 2015. In this case, the plan can treat up to $500 of the remaining $800 on December 31, 2014 as a carryover immediately available as of January 1, 2015 to pay expenses incurred in 2015.

If, in 2015 and before the end of the 2014 run-out period, the plan pays out a $2,700 claim incurred in January 2015 (using the full $2,500 pledged for 2015 by the participant and $200 of the $800 remaining as of December 31, 2014 as a carryover), the amount available to pay expenses incurred in 2014 and submitted during the 2014 run-out period is reduced by $200. This means that the amount available to pay 2014 expenses submitted during the 2014 run-out period is now only $600 (i.e., the $800 remaining as of December 31, 2014 is reduced by the $200 used as a carryover to pay 2015 expenses). If the participant submits $350 of 2014 expenses before the end of the 2014 run-out period, the amount remaining at the end of the 2014 run-out period is $250 ($600 minus $350 = $250). This $250 is available as a carryover for 2015 expenses. If the participant submits no further claims for 2015, the $250 is a potential unused carryover amount for 2016.

The Notice provides other examples of the logistics of the carryover.

Any unused amounts remaining as of the end of the run-out period for the plan year in excess of $500 must be forfeited. The Notice also provides that unused amounts remaining in a participant’s Health FSA upon termination of employment are forfeited. Thus, the only exception to forfeiture upon employment termination is if the employee elects COBRA under the FSA. And even in that case, for most Health FSAs, COBRA is generally only available (under a special durational rule) for the remainder of the plan year in which the termination of employment occurs. Since the carryovers apply to the next plan year, from a practical standpoint, this means that the only Health FSA participants that can take advantage of the $500 carryover rule are those employed on the last day of the plan year.

Either a Grace Period or Carryover – But not Both

A Health FSA may provide for a carryover only if it does not contain grace period provisions. As noted above, grace period provisions allow participants to use FSA year-end account balances for qualified medical expenses incurred during the first 2-1/2 months following the end of the plan year.

While no employer is required to use a grace period or allow a carryover in its Health FSA, employers who want to modify the use it or lose it rule will need to determine whether the carryover or grace period is better for their employee population. Likewise, employers that already have grace period provisions in their Health FSAs will need to determine whether to eliminate the grace period in favor of the carryover. If, typically, $500 or less remains in accounts at the end of the year, the $500 carryover might be more advantageous since the funds can be used for expenses incurred at any time during the next plan year. With the grace period, FSA participants are limited to using any remaining funds (including funds in excess of $500) only to reimburse expenses incurred during the first two months and 15 days of the next plan year.

But watch – what we don’t know is how a Health Flexible Spending Account carryover for a year (for example, a carryover for 2015) might impact an employee’s eligibility to make or receive health savings account (HSA) contributions in the same year. For Health FSAs that have grace periods, there is a special IRS procedure addressing how the grace period works in tandem with HSA eligibility. Since no procedure has been established for how the carryover works with HSA eligibility, employers offering high deductible health plans with Health Savings Accounts (or contemplating offering such programs), may want to wait for further governmental guidance before modifying their plans to either eliminate a grace period in favor of the carryover or adding a carryover.

Required Plan Amendments

To utilize the new carryover option:

  1. The plan must be amended 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: (1) the plan provides notice of the carryover to the participants; and (2) the plan operates in accordance with the guidance in the Notice.
  2. The plan can be amended to allow unused amounts from 2013 to carryover to 2014 any time before the last day of 2014 Plan Year, with the following exception for plans currently utilizing a grace period.

    A plan using a grace period must also be amended to eliminate the grace period by no later than the end of the plan year from which amounts may be carried over. So technically, a calendar year plan with a grace period could be amended by the end of 2013 to eliminate the 2013 grace period (that occurs in the first 2 ½ months of 2014) and to instead use the carryover. However, practically speaking, and as the IRS cautions in the Notice, the ability to eliminate a grace period provision previously adopted for a plan year may be constrained by other laws. Further, participants may have relied on the ability to use the entire amount of funds unused as of the end of the 2013 plan year (which could be significantly more than $500) for expenses incurred during the 2013 plan year grace period (i.e., the first 2 ½ months in 2014).

Given the fact that the Notice was issued so late in the calendar year (after most calendar year plans have already started open enrollment for 2014), employers with calendar year plans currently using a grace period that want to substitute the carryover should consider making the change first effective for amounts pledged to Health FSAs for 2015. This will give the employer the opportunity to notify participants of the change and provide participants with the opportunity to plan their FSA salary reductions for 2015 accordingly.

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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