Use-or-Lose Relief Under Health FSAs

On October 31, 2013, the U.S. Department of Treasury and IRS issued Notice 2013-71 modifying the long-standing “use-or-lose” rule under employer-sponsored health care flexible spending account plans (Health FSA).  If a Health FSA meets tax requirements under Internal Revenue Code Sections 105(h) and 125 and related regulations, then employees can set aside up to $2,500 of “before-tax” dollars from their gross pay into the Health FSA to reimburse them for certain eligible medical expenses.  One such IRC requirement is the use-or-lose rule that requires an employee to fully-spend down his or her FSA account balance during the 12-month plan year (or, if applicable, the “grace period” described below) and forfeit any unused balance existing after the close of such year. 

The IRS first issued relief from the harshness of the use-or-lose rule in 2005, when it established the grace period feature.  Under this feature, an employer optionally could decide to amend its Health FSA to provide participants with an additional 2-1/2 months after the close of the plan year to incur medical expenses and, thus, spend down unused account balances.  For example, a Health FSA with a calendar plan year could allow participants to incur medical expenses up through March 15, 2014, to spend down any account balance from the 2013 plan year.  Any unused dollars remaining in the FSA as of the end of the plan year (or its grace period, if applicable) would be forfeited.  For this purpose, the amount remaining unused as of the end of the plan year (or its grace period) is the amount unused after medical expenses have been reimbursed at the end of the Health FSA’s run-out claims period for the plan year (i.e. the period in which participants are permitted to request reimbursements after the close of the plan year (or after the close of the grace period, if applicable) with respect to eligible expenses that are incurred on or prior to the close of the plan year (or its grace period, if applicable)). 

Under Notice 2013-71, the Treasury Department and IRS recognized the need for additional flexibility with the operation of the use-or-lose rule due to the difficulty in predicting employees’ future needs for medical expenditures, the desirability of minimizing incentives for unnecessary spending at the end of a year or grace period, the possibility that lower- and moderate-paid employees are more reluctant than others to participate because of aversion to even modest forfeitures of their salary reduction contributions, and the opportunity to ease and potentially to simplify the administration of health FSAs.  Accordingly, a Health FSA may now permit up to $500 of the unused balance existing in a participant’s account on the last day of the plan year to be carried over and spent on eligible medical expenses incurred during the next plan year.  Any unused balance in excess of $500 would be still be forfeited under this new guidance.  An employer wishing to adopt the carryover feature for a plan year cannot also adopt or retain the grace period for the same plan year. 

The remaining information below sets forth additional considerations for employers sponsoring Health FSAs.

Plan Design Changes

In light of the new guidance under Notice 2013-71, the employer could decide to change its Health FSA plan design for the 2013 or future plan years, as follows:

• If the employer currently maintains a Health FSA with a grace period feature, the employer could decide to (i) retain the grace period feature under the Health FSA and not adopt a carryover feature, or (ii) amend the Health FSA to remove the grace period and replace it with the carryover feature.
• If the employer currently maintains a Health FSA without a grace period feature, the employer could (i) retain the use-or-lose rule requiring participants to spend down account balances by the last day of the plan year and forfeit unspent monies; (ii) adopt the carryover feature for the current plan year and subsequent plan years; or (iii) adopt a grace period feature for the current plan year and subsequent plan years. 

The employer must formally amend its Health FSA document to incorporate the carryover feature or the grace period feature.  The employer generally must adopt such a formal amendment to its Health FSA no later than the last day of the plan year from which amounts would be carried over or, alternatively for which the grace period would apply, and such amendment would be effective retroactively to the first day of that plan year.  However, Notice 2013-71 includes a special transition rule providing that an employer may amend its Health FSA to include the carryover feature for the 2013 plan year at any time on or before the last day of the 2014 plan year.  As noted above, the Health FSA cannot have both a carryover feature and a grace period feature for the same plan year. 

Informing Plan Participants

Notice 2013-71 requires employers to inform plan participants of its decision to add a carryover feature to the Health FSA.  While Notice 2013-71 does not specifically set forth a deadline to inform participants that a carryover feature has been added to the Health FSA, we recommend informing participants as soon as possible after the employer decides to add the carryover feature for a plan year.

Issues with Removing the Grace Period and Adding the Carryover Feature

While Notice 2013-71 implies that a Health FSA could be amended to eliminate the grace period feature and replace it with a carryover feature no later than the end of the plan year from which amounts may be carried over, it also cautions that eliminating a grace period feature previously adopted for a plan year may be subject to other legal constraints outside of the Internal Revenue Code and Notice 2013-71.  Accordingly, we do not recommend modifying the Health FSA to remove a grace period feature for any plan year that has already commenced. 

Example: If the Health FSA includes a grace period feature for the plan year ending on December 31, 2013, the grace period feature should be retained for the 2013 plan year.  The employer could then decide to adopt the carryover feature and remove the grace period feature for the 2014 plan year.  Although the employer would have until December 31, 2014, to formally amend the Health FSA under the facts of this example, we recommend that the employer informs plan participants as soon as possible, but no later than December 31, 2013, of its decision to eliminate the grace period feature and replace with the carryover feature for 2014 plan year.

Uniformity in Carryover Feature

If an employer amends its Health FSA to adopt a carryover feature, the same carryover limit must apply to all plan participants. 

Maximum Carryover and Annual Contribution Limits

The amount that a participant may carry over to the following plan year is equal to the lesser of (1) any unused amounts from the immediately preceding plan year or (2) $500 (or a lower amount specified in the Health FSA).  Any unused amount in excess of $500 (or a lower amount specified in the Health FSA) that remains unused as of the end of the plan year (that is, at the end of the run-out period for the plan year) is forfeited.  Any unused amount remaining in an employee’s Health FSA as of termination of employment also is forfeited (unless, if applicable, the employee elects COBRA continuation coverage with respect to the Health FSA).

The Health FSA must continue to annually limit employees’ pre-tax payroll deductions to no more than the indexed $2,500 salary reduction limit, plus any non-elective employer flex credits, plus the carryover amount of up to $500.

Coordination of Health FSA with HDHP-HSA Options

If the employer maintains a high deductible health plan with a health savings account (HSA) feature, the employer should consider coordination issues between the HSA and its Health FSA.  Namely, an employee generally would not be eligible to make or receive contributions to a HSA if he or she also is participating in a Health FSA, unless such Health FSA is amended to be a restricted purpose FSA covering only dental or vision expenses and/or post-deductible medical expenses.

Dependent Care FSA

The carryover feature under Notice 2013-71 applies only to a Health FSA and it does not apply to a Dependent Care FSA.  Dependent Care FSAs can, however, include a grace period feature and/or a special rule allowing terminated participants to spend down unused Dependent FSA balances until the last day of the plan year in which participation has been terminated. 

To learn more about employer options for their Health FSAs or IRS Notice 2013-71, please contact Amy Christen (achristen@dykema.com or 248-203-0760) or Gabe Marinaro (gmarinaro@dykema.com) or 313-568-6874).

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