The IRS has announced new, long-requested relief from the “use it or lose it” rule that will allow health flexible spending account (FSA) participants to carry over up to $500 of unused contributions to the next plan year if this feature is adopted by the plan sponsor. The catch is that an FSA cannot have both a carryover and a grace period, which means many plan sponsors will need to make a difficult decision as to which feature is best suited for their plan. The timing of the rule also poses problems if a plan sponsor wants to implement changes for the current 2013 plan year to allow carryovers to the 2014 plan year.

Current Rule and Grace Period Exception

The current rule is the familiar “use-or-lose” rule requiring that unspent contributions in an FSA at the end of a plan year be forfeited. In 2005, the IRS created the “grace period” exception that allows any unused amounts to be spent down during the 2-1/2 months following the plan year. Many FSA plans have adopted a grace period. Under Health Care Reform, health FSAs are now limited to $2,500 per year. In light of the new limit, the IRS announced in 2012 that it would consider modifying the use-or-lose rule.

New Carryover Benefit

In Notice 2013-71, the IRS modified the existing rules to allow a health FSA (but not a dependent care account) to adopt a carryover provision. The health FSA carryover allows up to $500 in unspent contributions (after claims submitted in the run-out period) to be carried over after the end of a plan year and used any time in the next plan year. The plan may adopt a carryover limit of less than $500, but the same limit must apply to all participants. The carryover does not affect the amount a participant can elect for the next plan year, so effectively up to $3,000 can be available, but the carryover is available even if no contributions are made the next year.

The Catch

Notice 2013-71 states that a health FSA cannot have both a carryover and a grace period applicable to the unspent amounts in a given year. Thus, a plan with a grace period must eliminate it in order to adopt the carryover. This can pose a difficult choice for an employer. On the one hand, the grace period allows more than $500 to be carried over, but only for a limited time. On the other hand, the carryover is capped at $500 but can be used up over an entire year. Some participants will be better off under one or the other. Any plan change will need to be clearly explained. If the FSA does not have a grace period, the sponsor only needs to weigh the administrative cost and loss of forfeitures from adding the carryover.

An example in the Notice shows that the carryover can be indefinite, continuing from year-to-year until it is used up or forfeited when the participant terminates. For example, a participant could carry over $500 from 2014 into 2015 and stop contributing to the FSA. If he/she only submits $200 in 2015, $300 would carry over to 2016, and so on. This extended spend-down feature may also deter sponsors from switching from the grace period to the carryover.

Replacing a grace period with a carryover provision may create another unintended consequence. The grace period can make an FSA participant who moves to an HSA-based plan ineligible to contribute the HSA for three months. A rule that allows a new HSA participant to contribute the full year’s amount in the first year of eligibility, even if eligible for only part of the year, alleviates the effect of the grace period. But since the carryover is available the entire following year, it presumably would prevent HSA contributions for the entire year. Thus, such a participant in a plan with a carryover would have to be sure to use up the entire account by the end of the year before moving to an HSA plan, unless the IRS gives us additional guidance.

Implementation Hurdles

The IRS Notice poses some implementation issues. Simply adding the carryover requires an amendment by the end of the year from which amounts may be carried over, but there is an extension for 2013, under which the amendment deadline is the last day of the plan year beginning in 2014. If the plan has a grace period, it must be eliminated by the end of the plan year from which amounts may be carried over—with no extension for 2013. Thus, a plan with a grace period that wants to change to the carryover for 2013 account balances will have to act by the end of this year—and explain the change to participants who had been expecting the grace period at the end of 2013. Action in 2014 seems more likely as employers ponder their choices.

Action Items

  • Review the operation of your cafeteria plan and consider whether a carryover provision is well-suited to the plan and your general health plan (such as whether you are converting to a HSA-based health plan).
  • Even if the employer will wait until 2014 to adopt the carryover, consider whether participant communications for 2014 open enrollment (underway now in some plans) should explain that the grace period may be replaced by a carryover at the end of 2014.

If you have any questions, please contact your usual Davis Wright Tremaine benefits lawyer.