The Internal Revenue Service (IRS) recently issued new guidance in Notice 2013-71 modifying the “use-or-lose” rules for health flexible spending arrangements (FSAs).  Under the new rules, plans can permit employees to carry over up to $500 of unused amounts in a health FSA in to the following year, provided the plan does not also incorporate the grace period rule.  The following highlights some important details about health FSAs and the new rules:

What are health FSAs? Health FSAs are typically offered as part of employers’ cafeteria plans.  A health FSA allows employees to be reimbursed for qualifying medical expenses.  FSAs are usually funded through voluntary salary reduction agreements with employers.  The employer may also contribute to the FSA.  Employees do not pay federal income tax or employment taxes on the salary they contribute or the amounts their employer contribute to the FSA.  For plan years after 2012, employees may contribute up to $2,500 to an FSA.  The $2,500 limit does not apply to non-elective employer contributions (sometimes referred to as flex credits).

How does the “use-or-lose” rule work?  The “use-or-lose” rule requires that FSA participants forfeit unused benefits or contributions remaining in a health FSA as of the end of the plan year.  In the past, employees with large balances at the end of the year would often spend those remaining amounts on qualifying items that they may not have otherwise purchased.  Under the new rules instead requiring participants to use remaining amounts or loose them, a plan may provide that up to $500 may be carried over into a subsequent plan year.

What is the “grace period rule”?  In 2005 the IRS modified the “use-or-lose” rule adopting a grace period rule, which allowed employees to use amounts remaining from a previous year to pay expenses incurred for qualified medical expenses during the period of up to two months and 15 days immediately following the end of the plan year.

I am an employer, what do I need to do to implement the new $500 carryover?  An employer must amend its 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.  If a plan has provided for a grace period and is being amended to add a carryover provision, the plan must also be amended to eliminate the grace period provision.

When do plan amendments need to be made?  Generally, the amendment must be adopted on or before the last day of the plan year from which amounts may be carried over and may be effective retroactively to the first day of that plan year.  However, for amendment effective for 2013 plan years the guidance allows an extra time.  Amendments adopting the $500 carryover allowance for plan years that begin in 2013 may be made at any time on or before the last day of the plan year that begin in 2014 (for calendar plan years that means December 31, 2014).

If an FSA allows the $500 carryover, can it also utilize the grace period rule?  No.  A plan can allow a grace period—i.e., an extra 2 and ½ months—for a participant to spend any unused amount at the end of a plan year, or it can allow a participant to carryover up to $500, but not both.

If my plan currently allows a grace period and I decide to adopt the $500 carryover rule starting 2014, can the plan still have a grace period for unused 2013 amounts for the beginning of 2014?  Yes.  A calendar year plan permitting a carryover to 2015 of unused 2014 health FSA amounts would be permitted to have had a grace period during the first 2½ months of 2014, but would not be permitted to have a grace period in 2015.

If an employee carries over the $500 maximum into 2014, can the employee still contribute $2,500 to his or her FSA for 2014?  Yes.  The carryover of up to $500 does not count against or otherwise affect the $2,500 limit applicable to employee contributions each plan year.

Jonathan C. Landon
Jonathan Landon is an Attorney and Vice President with Shuttleworth & Ingersoll, P.L.C. Jon advises individuals, businesses, and tax-exempt organizations in: Federal and state tax matters; general business transactions; deferred compensation and employee benefits; and estate and succession planning.