Alternative to Use-It or Lose-It

A Health Flexible Spending Account (“FSA”) provided under an employer’s §125 plan allows participants to make pre-tax contributions to pay for qualified health expenses, which are paid by or reimbursed to them under the FSA on a tax free basis. Until October 31, 2013, however, there was one major drawback without alternative: namely, all FSA contributions not used by a participant by the end of the plan year were forfeited by the participant under the Internal Revenue Code’s “use it or lose it” rules.

IRS Notice 2013-71 announces that employers now have an alternative to the “use it or lose it” rule. A §125 plan providing an FSA may now provide that up to $500 of a participant’s unused FSA contributions can be carried over and used in the following plan year, without limiting the annual FSA contribution limit for that following plan year.

Employers electing the carryover option, however, will not be permitted to provide a “grace period” (which allows unused contributions to be spent within 2½ months after the plan year-end) in the same plan year in which the carryover option is effective. Employers, therefore, will necessarily have to evaluate the advantages of having the grace period available to participants under the “use it or lose it” rule, compared to having up to $500 of a participant’s unused contributions carried forward into the following plan year, understanding that unused participant contributions in excess of the permitted $500 carryover amount will be forfeited without the benefit of a grace period.

For employers interested in taking advantage of the carryover option, the §125 plan must be amended to set forth the carryover provision, with care given to ensure that any grace period is eliminated as part of the amendment. Generally, the amendment must be adopted on or before the last day of the plan year from which amounts are to be carried over. The amendment may be made effective retroactively to the first day of a plan year, but only if the plan operates in accordance with the Notice and participants are provided notice that informs them of the carryover provision. For a plan year beginning in 2013, the Notice allows that a plan can be amended at any time on or before the last day of the plan year that begins in 2014.

Should you have any questions about a Health Flexible Spending Account, or IRS Notice 2013-71, please do not hesitate to contact Eugene Franks, Anders Gillis or any member of Smith Haughey Rice & Roegge’s Labor and Employment practice group.