On October 31, 2013, the IRS announced a significant change to the “use-or-lose” rule for health flexible spending arrangements (health FSAs) offered under cafeteria plans. The new law permits an employer sponsoring a health FSA to allow up to $500 of unused health FSA amounts remaining at the end of a plan year to be carried over for reimbursement of qualified medical expenses incurred during the following plan year. This relaxation of the “use-or-lose” rule is a welcome change for many employers who offer health FSAs to employees, but experience declining rates of participation in the health FSA once employees learn that they lose unused amounts at the end of a relevant plan year.
Health FSAs are subject to a “use-or-lose” rule under which unused contributions remaining at the end of the plan year are forfeited by participants. Some plans include a grace period under which employees can use amounts remaining from the previous year to pay expenses for certain benefits for up to two months and 15 days immediately following the end of a plan year. Under the IRS notice, employers can amend their cafeteria plans to permit the carryover to the immediately following plan year of up to $500 of unused amounts remaining at the end of a health FSA’s plan year (that is, after medical expenses have been reimbursed at the end of the plan’s run-out period).
- Can be used to reimburse health FSA medical expenses incurred during the plan year to which it is carried over; and
- Does not count against the annual health FSA limit.
Plans can choose a carryover amount of less than $500 (or not permit a carryover at all), but the same carryover limit must apply to all participants. The IRS provides other restrictions on how carryover amounts must be handled (for example, amounts cannot be cashed out or converted to other taxable or nontaxable benefits).
Plan Amendment Required
To take advantage of the carryover option, a cafeteria plan offering a health FSA must be amended to reflect the carryover provision. The amendment:
- Must be adopted by the last day of the plan year from which amounts can be carried over; and
- May be effective retroactively to the first day of the plan year from which amounts can be carried over, if:
- the cafeteria plan is operated consistent with the Notice; and
- Participants are informed of the carryover provision.
Employers that sponsor health FSAs should consult with their advisors to determine whether a carryover provision should be added to the health FSA and, if so, the appropriate carryover amount. An addition of the carryover provision will require a plan amendment and a change to the plan’s summary plan description in the form of a “summary of material modification.”