- IRS Modifies “Use It or Lose It” Rule for Health FSAs
- November 8, 2013 | Authors: Jeffery R. Banish; Josh F. Norris; Evelyn Small Traub
- Law Firms: Troutman Sanders LLP - Atlanta Office ; Troutman Sanders LLP - Richmond Office
The IRS has issued Notice 2013-71 announcing a change in the “use it or lose it” rule for healthcare flexible spending accounts (Health FSAs). The “use it or lose it” rule generally requires unused amounts in the participant’s Health FSA at the end of the plan year to be forfeited (although the 2 1/2 month grace period rule, if implemented, gives participants an additional 2 1/2 months to spend those unused account balances).
The New Carryover Rule
Under the new guidance, a plan sponsor may now, at its option, permit each Health FSA participant to carryover up to $500 of any unused account balance at the end of the plan year to the immediately following plan year. The carried over amount will not affect the ability of the participant to contribute the full $2,500 limit in the year to which the carryover is made. Therefore, in a carryover year, the participant can have up to $3,000 available for healthcare reimbursements, e.g., the $500 carryover and the full $2,500 current year contributions. In this case, the uniform coverage rule (which requires the maximum amount of reimbursement from the Health FSA to be available at all times during the period of coverage) will apply for the full $3,000 available reimbursement in the carryover year. In addition, if elected by the plan sponsor, the carried over amount may be deemed to be used first, before the contributions for the current year.
The Notice gives the following example:
Example: A Health FSA is operated on a calendar year basis, allows each participant to elect a salary reduction amount up to $2,500 per year for the participant’s Health FSA, and there is a run-out period from January 1 to March 31 pursuant to which the participant has until March 31 to submit claims for reimbursements for healthcare expenses incurred by December 31. The Health FSA is timely amended to provide for a carryover that allows each participant to apply up to $500 of unused amounts remaining at the end of year to the Health FSA for the following year.
In November 2014, Participant A elects a salary reduction amount of $2,500 for 2015. By December 31, 2014, A’s unused balance in the Health FSA is $800. On February 1, 2015, A submits claims and is reimbursed with respect to $350 of expenses incurred during 2014, leaving a carryover on March 31, 2015 (the end of the run-out period) of $450. The $450 amount is not forfeited; instead, it is carried over to 2015 and available to pay claims incurred in that year, so that $2,950 (that is, $2,500 + $450) is available to pay claims incurred in 2015. A incurs and submits claims for expenses of $2,700 during the month of July 2015 and does not submit any other claims during 2015. A is reimbursed for the $2,700, leaving $250 as a potential unused amount from 2015 (depending upon whether A submits claims during the 2015 run-out period in early 2016).
By contrast, under the 2 1/2 month grace period rule, which has been in existence since 2005, Health FSAs can permit a participant to use amounts remaining from the previous year to pay expenses incurred for certain qualified benefits during the period of up to 2 1/2 months immediately following the end of the plan year. The grace period is different than the run-out period. During the run-out period, only expenses incurred by the end of the applicable plan year can be reimbursed; this rule simply gives the participant additional time to submit claims for the year. The grace period actually permits the participant to use the remaining balance to pay claims in the following year. In deciding whether or not to modify an existing Health FSA to incorporate the new carry over rule, it is important to note that the carryover rule and the 2-1/2 month grace period are mutually exclusive. Accordingly, if an existing Health FSA has a grace period, the plan sponsor is required to eliminate the grace period if the Health FSA is to be amended to allow participants to carryover any unused balance at the end of a plan year.
Open Issue - Interaction with Health Savings Accounts
Employees who are eligible for a traditional Health FSA are not eligible to contribute to a Health Savings Account (HSA). Therefore, participation in a traditional Health FSA that provided the grace period precluded HSA contributions until the first calendar month after the grace period ended. The Notice does not address the impact of the new carryover rule on the ability to make HSA contributions. Participation in a limited-purpose Health FSA (i.e., one that limits reimbursements to dental, vision and preventive care expenses and post-deductible expenses) does not preclude HSA contributions. One way to view this is to consider the carryover to be subject to the rules of the Health FSA that are appropriate for the participant (traditional versus limited-purpose) in the year to which the balance is carried over. Alternatively, the participant may be precluded from making HSA contributions until the carryover is fully used. Hopefully, the IRS will clarify this interplay soon.
Amending Plans to Use the Carryover Rule
In order to take advantage of the new carryover rule, plans must be amended to implement the new rule no later than the end of the plan year from which the amounts are to be carried over. But, for years that began in 2013, the amendment deadline is extended to no later than the end of the 2014 plan year. This extension does not appear to apply to an amendment to eliminate the grace period, which may be required in order to implement the carry over. We would advise that plan sponsors who want to amend calendar-year Health FSAs that currently have a grace period amend by December 31, 2013. Participants also will need to be promptly informed of any change so they can make the appropriate choices during open enrollment.