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IRS Issues Guidance Allowing Health FSA Carryovers

    Client Alerts
  • November 08, 2013

Last week, the Internal Revenue Service (“IRS”) published Notice 2013-71, which provides guidance on the circumstances under which employers may amend their cafeteria plans to allow a carryover of up to $500 of unused amounts remaining in a health flexible spending account (“FSA”) at the end of a plan year to the next plan year.
As background, a cafeteria plan must allow employees to choose between two or more benefits consisting of cash and certain nontaxable benefits, including a health FSA. Because a cafeteria plan generally may not provide for deferred compensation, the “use-it-or-lose-it” rule has required that unused contributions at the end of a plan year must be forfeited. Several years ago, the IRS modified this rule to allow a plan to provide that unused health FSA amounts from one year may be used to pay expenses incurred during a 2½ month “grace period” immediately following the end of the year. This exception was based on other areas of tax law that do not characterize certain arrangements as deferred compensation if the payment is made not later than 2½ months after the end of the applicable year (for example, the short-term deferral exception under Internal Revenue Code §409A). Neither the grace period nor the new carryover provision affects the ability of a health FSA to provide for a run-out period during which expenses incurred during a year may be submitted and reimbursed at the beginning of the following plan year.
Under the current notice, an employer may amend its cafeteria plan to allow carryover of unused health FSA amounts of up to $500 to the next plan year. The carryover amount is determined after taking into account claims paid for the prior year during any run-out period, which may complicate administration since the amount available for carryover may not be known until the end of the run-out period. In addition, the carryover amount does not affect the $2,500 annual limit on employee pre-tax contributions to a health FSA. However, a health FSA may not include a grace period in a plan year to which carryovers are permitted.
This means that plan sponsors who want to offer either a grace period or a carryover opportunity will have to choose the provision that will apply under their plans, and the provision must apply uniformly to all plan participants and cannot be determined or elected for each individual employee. The amendment to adopt a carryover provision must be adopted by the last day of the plan year from which amounts may be carried over, but solely for the 2013 plan year, the amendment may be adopted by the last day of the 2014 plan year. If a carryover provision is adopted, the plan must be amended at the same time to eliminate any grace period provision. 
Employers should consider whether to adopt carryover provisions, including advantages and disadvantages. For example, adding a carryover provision may benefit employee morale in some cases, although it also will result in a loss of Health Savings Account (HSA) eligibility for the next year (unless the health FSA is limited purpose). Employers with health FSAs that already include a grace period should consider whether to eliminate the grace period and adopt a carryover provision. However, the ability to eliminate an existing grace period after the beginning of the plan year may be limited by factors other than the recent notice, such as communications to employees and reliance by employees on the availability of a grace period in scheduling their medical treatment.