Recent changes announced by the Internal Revenue Service (IRS) modify the “use-it-or-lose-it” rule that applies to health flexible spending arrangements (FSAs). Plan sponsors will now have the option of allowing participants in health FSAs to carry over up to $500 of unused funds in a health FSA to the following plan year.

Background
Health FSAs are tax-advantaged employer-provided benefit plans that employees can use to pay for qualifying medical expenses. While generally funded through voluntary employee salary reductions, employers are able to contribute as well. Prior to the start of a plan year, employees decide how much to contribute to the health FSA (the maximum annual employee contribution to a health FSA that is part of a cafeteria plan is $2,500 for 2014). Contributions to the plan are excluded from income for federal income tax purposes, as are any reimbursements made from the plan for qualified medical expenses, including co-payments, deductibles, and dental and vision care expenses.

Any funds left unspent in the health FSA at the end of the plan year are forfeited–this is commonly referred to as the “use-it-or-lose-it” rule. Plan sponsors have the option of providing for a grace period of up to 2½ additional months after the end of the plan year (e.g., a calendar year plan might cover expenses incurred through March 15).

 New rules
In Notice 2013-71, the IRS modified the “use-it-or-lose-it” rule that applies to health FSAs:

Plans may now be amended to allow participants to carry over up to $500 of unused health FSA funds at the end of a plan year.
Any carryover will not count against the $2,500 limit in the next plan year.
A plan may allow participants a grace period, as described above, or the ability to carry over unused funds–but not both.
A plan does not have to allow either the grace period or the carryover option.
To adopt the carryover option, plans must be amended on or before the last day of the plan year from which amounts may be carried over, and may be retroactive to the first day of the plan year, provided certain requirements, including participant notification, are met.
Special rules apply to plan years beginning in 2013–these plans may be amended to retroactively adopt the carryover provision at any time on or before the last day of the plan year that begins in 2014.

 Word of caution
A health FSA plan can’t have both a grace period and a carryover option, so plans with existing grace periods will have to be amended to remove the grace period feature in order to add carryovers. Plan sponsors should consult carefully with a benefit specialist before taking any action, however, as eliminating an existing grace period feature raises potential issues relating to the Employee Retirement Income Security Act of 1974 (ERISA). IRS Notice 2013-71 itself states that “the ability to eliminate a grace period provision previously adopted for the plan year in which the amendment is adopted may be subject to non-Code legal constraints.”
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