IRS Relaxes Use-It-Or-Lose-It Rule for Health Flexible Spending Accounts

by Sherman & Howard L.L.C.

On October 31, 2013, the Internal Revenue Service (the “IRS”) issued Notice 2013-71, which relaxes (but does not eliminate) the “use-it-or-lose-it” rule for health flexible spending accounts (“Health FSAs”) under Code Section 125. Health FSAs are accounts that are available under employer-sponsored cafeteria plans for employees to utilize in order to pay for qualified unreimbursed medical expenses on a tax-free basis. Normally, an employee must elect to defer his or her taxable compensation to the Health FSA for the entire year and, if the contributed amount is not utilized to pay for qualified medical expenses, the remaining amount is forfeited by the employee. The relaxation of the “use-it-or-lose-it” rule will allow employees with Health FSAs to carry over up to $500 of unused amounts under their Health FSAs from one plan year into the following plan year, provided the sponsoring employer amends its cafeteria plan to add this new $500 carryover rule.

Because the Notice is effective immediately, employers who sponsor Health FSA plans may still amend their cafeteria plans for the 2013 year to take advantage of the new rule. For a 2013 calendar year plan, the amendment must be executed no later than December 31, 2013.

Details of the New Carryover Rule

The IRS introduced the new carryover rule in order to increase flexibility under cafeteria plans and to help reduce the tendency of employees to spend down their contributions by the end of plan year on unnecessary expenses. Employees of employers who choose to amend their cafeteria plans to include the new carryover rule, who have unused amounts remaining in their Health FSAs at the end of the plan year, may carryover up to $500 of the unused amounts to be utilized for qualified expenses incurred in the next plan year. Any unused contributions remaining after the $500 amount is carried over will be forfeited.

For example, an employee with $600 remaining under his Health FSA as of December 31, 2013, may choose to carryover $500 of that unused $600 amount to the 2014 plan year, to be utilized in addition to the amount (up to $2,500 for the 2014 plan year) that the employee elects under his Health FSA to be used for qualified expenses for the 2014 plan year. Note, however, that due to the $500 cap on the carryover amount, the remaining $100 of the unused $600 amount for 2013 still will be forfeited as of December 31, 2013. The new carryover rule therefore does not entirely eliminate the effects of the original “use-it-or-lose-it” rule.

New Carryover Rule Comes at a Price

For employers who wish to take advantage of the new carryover rule, note that the adoption of this new rule comes at a price: if a Health FSA already is taking advantage of the “grace period rule”, which allows reimbursements to employees from Health FSAs to be paid for qualified expenses incurred up to two and a half months after the end of the plan year, the plan may not also use the new carryover rule. In other words, employers must choose between the two rules, and those who wish to utilize the new carryover rule under their plans that already utilize the grace period rule must amend their plans to remove the grace period rule at the same time that the new carryover rule is added.

Note that in some cases employees may benefit more from the grace period rule than the new carryover rule. For example, in the example above where an employee still has $600 unused at the end of 2013, if that employee were to utilize that amount for qualified expenses incurred within the first two and a half months after the end of the plan year (i.e., by March 15, 2014), then that employee would not forfeit any amount under the grace period rule, in contrast to the $100 that would be forfeited under the new carryover rule.

IRS Notice 2013-71 Does Not Affect Run-Out Period

Regardless of whether an employer chooses to utilize either the grace period rule or the new carryover rule (or neither), IRS Notice 2013-71 does not affect the “run-out period” under a cafeteria plan (unless the “run-out” period is timed on the end of the grace period, in which case the run-out period may be shortened if the grace period is eliminated). The “run-out period” is the period immediately following the end of the plan year, during which an employee can submit a claim for reimbursement of qualified expenses incurred during the plan year. As a result, employees of employers who choose to amend their plans to include the new carryover rule still will be able to submit their requests for reimbursement from their Health FSAs for expenses incurred in 2013 during the applicable run-out period provided for under their cafeteria plan.

Deadline to Amend Cafeteria Plans to Utilize New Carryover Rule for 2013

Employers who wish to utilize the new carryover rule under their cafeteria plans for 2013 must amend their cafeteria plans no later than the last day of the 2013 plan year, and must make sure to provide information to employees as soon as possible so that they can plan for the new rules. For calendar year plans the amendment deadline is December 31, 2013. In addition, employers who wish to amend their cafeteria or flex plans to remove the grace period so that they can add the carry over provision must provide notice of that amendment to the participants in the plan within 60 days after that amendment is adopted. Our Employee Benefits Group is ready to assist employers with analyzing the potential impact of the new carryover rule on their cafeteria plans, and with amending their cafeteria plans, if desired.


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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