IRS Issues Modification of "Use or Lose" Rule for Health Flexible Spending Arrangements

Wednesday, November 20, 2013
The IRS presented guidance (Notice 2013-71) modifying its "use it or lose it" rule to allow employers to amend their plans and allow employees to carry over up to $500 of unused money in a health flexible spending account (FSA) from one plan year to the next under under §125 cafeteria plans. 

Under current regulations for cafeteria plans under Section 125, a health FSA participant generally forfeits any money left in the FSA at the end of the plan year. Certain exceptions include the run-out period and the grace period. The run-out-period rule allows plan sponsors to specify a run-out period after the end of a plan year when participants can be reimbursed for medical costs incurred during the plan year that are submitted during the run-out period. Under the grace-period rule, the plan may allow an employee to use amounts remaining in the plan from the previous year to pay medical expenses incurred during the period up to two months and 15 days immediately following the end of the plan year. Currently, any amounts remaining in the plan after the optional run-out or grace period are forfeited.

Plan sponsors now have the option to amend their plans to allow up to $500 of unused funds in the health FSA to carry over to the next plan year. In general, the cafeteria plan amendment must be adopted on or before the last day of the plan year for which amounts may be carried over. The amendment may be retroactive to the first day of that plan year, provided that the plan operates in accordance with Notice 2013-71 and informs the participants of the carryover provision. For plan years that began in 2013, the plan may be amended any time on or before the last day of the plan year that begins in 2014. Accordingly, an employer, at its option, is permitted to amend its § 125 cafeteria plan document to provide for the carryover to the immediately following plan year of up to $500 of any amount remaining unused as of the end of the plan year in a health FSA.

The carryover of up to $500 may be used to pay or reimburse medical expenses under the health FSA incurred during the entire plan year to which it is carried over. For this purpose, the amount remaining unused as of the end of the plan year is the amount unused after medical expenses have been reimbursed at the end of the plan’s run-out period3 for the plan year. In addition to the unused amounts of up to $500 that a plan may permit an individual to carry over to the next year, the plan may permit the individual to also elect up to the maximum allowed salary reduction amount under § 125(i). Thus, the carryover of up to $500 does not count against or otherwise affect the indexed $2,500 salary reduction limit applicable to each plan year.

A health FSA that is amended to include the carryover option is permitted to have a run-out period but not a grace period. If a plan has included a grace period and is being amended to add a carryover provision, the plan must also be amended to eliminate the grace-period provision by no later than the end of the plan year from which amounts may be carried over. The elimination of a grace-period provision may be subject to nontax legal constraints.

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