BRIAN GILMORE, November 2013 —
Plan sponsors and participants have reason to rejoice. The IRS has relaxed Code section 125’s rigid use-it-or-lose-it rule for health flexible spending accounts (“Health FSAs”) by allowing up to $500 of unused contributions to carry over into the following plan year. For plan sponsors, this will help address the administrative burden in handling forfeitures of unused account balances. For participants, this will reduce the difficulty of making Health FSA elections, prevent many unnecessary medical expenditures at the end of the plan year, and allow up to $500 of Health FSA funds to carry over into the next year rather than being forfeited.
The IRS announced this new carryover option for Health FSAs on October 31, 2013 in IRS Notice 2013-71 (the “Notice”). As described below, the Notice presents a number of important new considerations for plan sponsors.
What is the New $500 Carryover?
Under the Notice, Health FSAs now can permit participants to carry over up to $500 remaining in their Health FSA balance at the end of the plan year (and any run-out period) into the following plan year. The carryover option is not available for a dependent care assistance plan (sometimes referred to as a DCAP or dependent care FSA).
For example, assume that a participant elected to contribute $2,500 to his employer’s Health FSA in the 2014 calendar-year plan year. The participant incurs $1,850 of out-of-pocket medical expenses in 2014 that are reimbursed by the Health FSA, leaving a remaining balance of $650 at the end of the run-out period. If the Health FSA has adopted the new carryover feature, $500 of the participant’s unused Health FSA balance will carry over into the 2015 plan year. The remaining $150 will be forfeited. If the participant again elects $2,500 for the 2015 plan year, the participant will have $3,000 ($2,500 election + $500 carryover) available for reimbursement in 2015.
Does the $500 Carryover Count Toward the $2,500 Health FSA Salary Reduction Limit?
No. The carryover amount of up to $500 does not apply to the new $2,500 Health FSA election cap. Thus, as demonstrated in the example above, a participant who carries over $500 from the 2014 plan year may still elect $2,500 for the 2015 plan year. The participant would then have $3,000 available for reimbursement in the 2015 plan year.
Note that the IRS also announced on October 31, 2013 that the $2,500 Health FSA employee contribution limit, which is indexed for inflation, will remain unchanged for the 2014 plan year.
Is the Cafeteria Plan Required to Offer the Health FSA Carryover?
No. As with a run-out period or grace period, the carryover feature is optional. The Health FSA may decline to offer a carryover, offer the maximum carryover of up to $500, or specify a carryover limit of less than $500 (e.g., up to $250).
What about Grace Periods?
The most significant limitation in the Notice is that a Health FSA cannot have a grace period if it adopts a carryover feature.
A grace period is an optional Health FSA provision that allows participants to incur reimbursable expenses for up to two months and 15 days after the end of the plan year. For calendar-year plans, the grace period allows participants who did not exhaust their Health FSA balance by December 31 to submit claims for expenses incurred on or before March 15 of the following plan year. Plan sponsors must eliminate any Health FSA grace period provision from the plan in order to add the carryover.
Note that the grace period is different from a run-out period, which is a separate optional Health FSA provision that offers participants extra time to submit claims incurred during the previous plan year and associated grace period. Unlike the grace period, participants cannot incur any new expenses during the run-out period. The Health FSA may continue to offer a run-out period even if it adds the carryover feature.
What are the Plan Document Amendment Requirements?
Health FSAs are a component of a Section 125 cafeteria plan. The Notice provides that plan sponsors must amend the cafeteria plan document to utilize the new Health FSA carryover feature.
For plans that will add the carryover feature for the plan year beginning in 2013, the amendment must be executed by the end of the plan year beginning in 2014. For all future plan years, the amendment must be executed by the end of the last day of the plan year from which amounts may be carried over. For example, a calendar-year plan wishing to add the carryover in 2014 by allowing participants to carryover up to $500 in unused 2014 Health FSA amounts into the 2015 plan year must amend the cafeteria plan document on or before December 31, 2014.
The carryover plan amendment may be retroactive to the beginning of the plan year. Plus, as noted above, a special 2013 transition rule allows plan sponsors to amend the plan by the end of the plan year beginning in 2014 with retroactive effect to the beginning of the plan year beginning in 2013. In either case, the retroactive application is valid only if the cafeteria plan operates in accordance with the Notice for the entire period and the plan sponsor informs participants of the carryover provision.
Plan sponsors adding a carryover to a Health FSA that currently offers a grace period must amend the plan document to eliminate the grace period. The amendment to eliminate the grace period must also be adopted by the end of the plan year in which the carryover feature is added. However, it appears there is no special 2013 transition rule for amendments to eliminate a grace period.
What are the SMM/SPD Disclosure Requirements?
In addition to the IRS’s disclosure requirement from the Notice, Health FSAs are subject to ERISA, which requires that material modifications be disclosed to participants in an SMM or updated SPD. The addition of a carryover provision must be disclosed in either form no later than 210 days after the end of the plan year in which it is adopted. Plans eliminating a grace period in order to add the carryover provision will need to distribute an SMM or updated SPD describing the material reduction in group health plan covered benefits within 60 days of adopting the change.
In either case, the best practice for plan sponsors is to, where possible, disclose the Health FSA change prior to the end of the election period for the plan year in which it will apply so that participants can account for the change when making their election.
Open Issue — Does the Health FSA Carryover Affect HSA Eligibility?
Individuals who are covered by a general-purpose Health FSA (whether as the employee-participant or as a spouse or dependent whose qualifying expenses are eligible for reimbursement) are not eligible to make or receive contributions to a health savings account (“HSA”). It is not clear at this point whether individuals who carry over general-purpose Health FSA amounts into a subsequent plan year, and would otherwise be HSA-eligible (i.e., they have HDHP coverage and no other disqualifying coverage), are ineligible to make or receive HSA contributions for that entire subsequent plan year. Guidance from the IRS on this issue would be welcome.
Future Guidance
The IRS intends to amend the proposed cafeteria plan regulations (which have been in proposed form since 2007) to reflect these new $500 carryover provisions. Plan sponsors can rely on the guidance in the Notice until the IRS issues updated regulations.
