Health FSA Use-It-Or-Lose-It Rule Modified to Allow a $500 Carryover

On Thursday, the IRS issued Notice 2013-71, which permits companies to amend their Sec. 125 cafeteria plans to allow participants in health flexible spending arrangements (FSAs) who do not use all of the money in a plan year to use up to $500 in the next plan year, in addition to the regular $2,500 limit during the succeeding year. Employers may amend their cafeteria plans to adopt the carryover provision for the current cafeteria plan year or any subsequent plan year.

The new carryover rule offers an alternative to the current grace period rule, and companies that adopt this new carryover rule are not permitted to also offer the grace period. Under the grace period rule, introduced in 2005, a cafeteria plan can allow participants to spend unused amounts in the first two months and fifteen days after the beginning of the next plan year.

Health FSAs in cafeteria plans permit employees to pay for qualified medical expenses such as co-pays and deductibles, eyeglasses, and hearing aids on a pretax basis. Usually, once the plan year ends, employees lose any money left in the accounts under the use-it-or-lose-it rule (unless the employer offers the grace period). This new carryover rule helps employees by allowing them to make the election without worrying they will forfeit some of their money and to lessen the incentive to make wasteful purchases (such as for a third pair of eyeglasses) at the end of a year to exhaust the funds.

Employers are not required to allow the $500 carryover (and can also set a lower limit) or the grace period, but to participate, employers must amend their plans on or before the last day of the plan year for which amounts may be carried over, and may be effective retroactively, provided certain requirements are met.

The notice also clarifies how the transition rules for non-calendar-year cafeteria plans will work for changing cafeteria plan elections after the first day of the 2013 plan year. Normally, cafeteria plan elections must be made before the start of a plan year and cannot be changed after the start of that year unless a change-in-status event occurs. The preamble to the proposed Sec. 4980H regulations issued in January (REG-138006-12) provided a transition rule for non-calendar-year plans so participants could take advantage of the benefits under the health care act, such as the ability to purchase insurance in a health care exchange, that take effect at the start of 2014.

Specifically, the transition relief allows an employer, at its election, to amend one or more of its written Sec. 125 cafeteria plans to allow employees to either make a prospective salary reduction election for accident and health coverage on or after the first day of the 2013 plan year or to prospectively revoke or change his or her election with respect to the accident and health plan once during that the 2013 plan year, whether or not the employee experienced a change in status event.

Based on the language in the preamble to the regulations, this transition rule for plans that were on non-calendar years seemed to apply only to applicable large employers subject to the Sec. 4980H employer mandate. In this notice, the IRS clarified that the relief is available to an employer with a Sec. 125 cafeteria plan non-calendar plan year beginning in 2013 whether or not the employer is an applicable large employer or applicable large employer member under Sec. 4980H.