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IRS Loosens Health FSA Carryover Rules

Recent IRS guidance creates a new exception to the “use-it-or-lose-it rule” that has long discouraged employees from contributing to a health flexible spending account (“health FSA”). Sponsors of health FSAs may now allow employees to carry over up to $500 of their account balance from one plan year to the next, thereby reducing their risk of incurring a forfeiture. This “carryover” option is immediately available (even for 2013), but sponsors wishing to implement the option for either 2013 or 2014 will need to act quickly.

Compared to the 2 ½-Month Grace-Period Option

As described in IRS Notice 2013-71, this new option allows for up to $500 of an employee’s account balance (whether attributable to the employee’s own salary deferrals or an employer’s contributions) to be carried over from one plan year to the next. Importantly, however, this is an alternative to the option of granting employees a 2 ½ month “grace period” for incurring covered claims. The two options may not be offered during the same plan year.

Moreover, the prohibition on offering both options during the same year applies on a plan-wide basis, and not merely employee-by-employee. A health FSA could not allow employees to elect between the two options (or even give each employee whichever option would be most advantageous for that employee). Each sponsor must thus consider which option (if either) makes the most sense for its overall workforce.

This is where the differences between the two options will be important. Under the grace-period option, an employee with an account balance remaining at the end of a plan year may continue to use that balance to reimburse claims incurred during only the first 2 ½ months of the following plan year – but with no dollar limit on the amount of those reimbursements (other than the employee’s overall account balance). The new carryover option allows for only $500 of a year-end account balance to be carried into the following plan year, but to be used to reimburse claims incurred at any time during that year.

Other Considerations

The Notice emphasizes that the $2,500 cap on an employee’s annual salary deferral contributions to a health FSA will continue to apply. However, any carryover allowed under this new provision will be in addition to that amount. Thus, an employee who carries over $500 from one year to the next could still contribute up to the full $2,500 during that second year – thereby having up to $3,000 available for reimbursement of covered medical expenses incurred during that year.

As with the 2 ½ month grace period, this new carryover option is entirely optional on the part of a health FSA sponsor. A sponsor is also free to specify a maximum carryover amount of less than $500 – so long as the cap applies equally to all employees. Sponsors who have relied on forfeitures to offset losses attributable to the “uniform coverage rule” might consider a lower carryover cap as a way of minimizing the cost of this new option.

Many of the same considerations that gave rise to the grace period option are cited by the IRS in support of this carryover option. These include the difficulty employees have in predicting their future (uninsured) medical expenditures, a desire to minimize incentives for employees to engage in unnecessary medical spending at year-end simply to zero out their account balances, and the possibility that lower-paid employees may be avoiding health FSAs due to a reluctance to incur even modest forfeitures.

Potential Administrative Pitfall

The IRS also supports this carryover option as a way of simplifying the administration of health FSAs. The jury is still out on that argument. For instance, an employee’s actual carryover amount cannot be determined until the end of any “run-out period” allowed for the submission of claims incurred during a plan year. These run-out periods often extend for as long as three months into the following plan year. So under a calendar-year FSA, the amount available for carryover may not be known until March 31st of the following year.

This means that special care must be taken when processing any reimbursement claims received by the FSA administrator during the first three months of that following year. Any of those claims that were incurred during the prior plan year may be paid only from carryover amounts.

However, any claims incurred during the first three months of the current plan year should be reimbursed from current-year contributions (including amounts the employer is required to advance under the uniform coverage rule) before any amount contributed during the prior year is used for that purpose. This is because the employee could still submit claims incurred during the prior year, thereby reducing – perhaps to zero – the available carryover amount. Individuals charged with administering health FSAs will need to be alert to these potential traps.

Amendment Deadline and Employee Communications

Any health FSA sponsor wishing to take advantage of this carryover option will need to amend its cafeteria plan document (under which the FSA is maintained) to provide for the option. Normally, the deadline for adopting such an amendment will be the last day of the plan year from which amounts may be carried. For plan years beginning in 2013, however, the Notice allows such an amendment to be adopted by the last day of the 2014 plan year.

A sponsor wishing to implement this option for 2013 should not be lulled by this extended amendment deadline, however. If the FSA already provides for a grace period, no carryover could be allowed unless that grace period is cancelled. Although the IRS might not object to such a cancellation, even the IRS notes that “other legal constraints” (think ERISA or state contract law) might make that impossible. At a minimum, employees who were counting on the ability to incur more than $500 of covered expenses during such a grace period would have reason to object to an amendment cancelling the grace period at this late date.

But even if a health FSA sponsor is thinking of waiting until 2014 to implement a carryover option, the option will need to be communicated to employees during the annual enrollment period for that plan year (which may already be underway). Employees should be informed that any grace period option will no longer apply, but that they need only come within $500 of accurately estimating their family’s uninsured medical expenses for 2014.

Despite the administrative pitfalls noted above, this new carryover option has the potential to do a great deal of good. Certainly, it may encourage more lower-paid employees to take advantage of the FSA option. Unfortunately, unless FSA sponsors aggressively explain the new option, it’s likely to be lost in all the noise generated by health care reform.