IRS Modifies Health FSA "Use or Lose" Rule

by McCarter & English, LLP

On October 31, the IRS issued Notice 2013-71, modifying the long-standing “use or lose” rule for health flexible spending arrangements (FSAs). Under the new rule, employers may permit health FSA participants to carry over up to $500 of their unused health FSA balances for use in the following year. The new rule applies to health FSA balances funded with employee contributions, employer contributions, or both. If the employer adopts the new rule, any unused health FSA balance in excess of $500 must be forfeited. The $500 (or lower) carryover does not count against the $2,500 limit on the participant's elective contributions to the health FSA for the next year.
Under the prior rule, an unused health FSA balance generally was required to be forfeited at the end of the year. That rule made it difficult for employees to determine how much to deposit in a health FSA, required complicated employee communications, and sometimes put employers in the position of requiring participants to forfeit their own contributions. However, IRS Notice 2005-42 permitted employers to adopt a year-end grace period, under which health FSA participants would not forfeit unused amounts if they were used by March 15 of the following year. Under the new rule, health FSAs may either use the existing March 15 grace period (which is not limited to $500) or permit participants to carry over up to $500 to the following year, or neither. The health FSA may not permit both the grace period and the $500 carryover.

Employers may adopt the new rule for 2013 account balances or choose to do so for 2014 or later years. A transitional rule permits an employer to adopt the written amendment for 2013 account balances at any time before the end of the 2014 plan year (generally, December 31, 2014).
Action Required Now
Employers should promptly consider whether to adopt the $500 carryover rule for the 2013 plan year, which would permit participants to carry over up to $500 of their unused 2013 balances for use in 2014. If employers adopt the new rule for 2013 health FSA balances, they must update explanations for participants, which potentially affects participants' elections for 2014. Employers may prefer to retain the grace period approach for the 2013 plan year instead of changing health FSA communications and election materials, which in some cases have already been distributed and which must be completed in the next two months or less. If the employer does not adopt the $500 carryover rule for the 2013 plan year, it could decide now or later in 2014 to permit carryovers of unused 2014 balances to 2015.
Employers should review their cafeteria plan and health FSA documents, as well as plan descriptions and enrollment materials, and revise them as necessary to make sure that they properly include the grace period or the $500 carryover rule for unused 2013 health FSA account balances.

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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