Guidance was recently issues that modified the Health FSA Use-or-Lose Rule to allow carryover of FSA funds from one plan year to the next plan year - at an employer's discretion. What does this mean?

1. Losing the “Use-or-Lose” Rule
On October 31, 2013, the Department of Treasury issued guidance in IRS Notice 2013-71 that
modified the longstanding Health FSA Use-or-Lose Rule to allow carryover of FSA funds from
one plan year to the next plan year at the employer’s option. This change addresses the single
biggest fear that employees have before enrolling in a Health FSA - losing money. Employers
that help their workforce learn about this exciting change should see an increase in participation
and election amounts, providing additional FICA savings.
$500
The Notice provides employers with the option to allow Health FSA participants to
have up to a $500 carryover of any unused amount to the next plan year. Employees
who were hesitant in the past may want to participate now since they will have a
safety net to avoid the worry of forfeiture.
Use-or-Lose historical perspective
Use-or-Lose was proposed by the IRS in 1981 to comply with §125 prohibition against
deferred compensation. In 2005, the rule was modified to allow a grace period, extending the
reimbursement time period up to two months and fifteen days after the end of the plan year. The
2007 Proposed Cafeteria Plan Regulations affirmed the Use-or-Lose Rule.
Use-or-Lose
rule is proposed
Rule was modified
to allow a grace period
Proposed Cafeteria Plan
Regulations affirmed
the Use-or-Lose Rule
Use-or-Lose Rule
eliminated
In IRS Notice 2012-40, the IRS indicated their openness to change the Use-or-Lose Rule. The
overwhelming response was to eliminate the rule. Reasons included the difficulty of predicting
future health care needs, reluctance to participate and lose money and the need to simplify
health FSA administration. The Notice now allows employers to do this with a carryover, but they
must eliminate the grace period.
Administrative convenience
The Notice allows Health FSAs to coordinate the carryover amount so that the new plan year’s
expenses are reimbursed from the new plan year’s salary reduction election first. This allows
the carryover amount to remain available for the prior plan year’s expenses during the run-out
period. If needed, the Health FSA can pull from the carryover amount to remiburse current plan
year expenses.
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2. Example: Fred is able to carry over $500 in his Health FSA into the 2014 calendar plan year. His
2014 election is $2,500. On January 4, 2014, he incurs a $2,750 expense. He has a $100 expense
that was incurred in 2013, but he does not
$500
submit it until January 11, 2014, during the runout period.
2013
2014
The FSA pays $2,500 from the 2014 election,
then the remaining $250 from $500 carryover.
The $250 balance is available to reimburse
the $100 expense incurred in 2013 submitted
during the run-out period. Fred now has $150
remaining for 2014.
Plan amendment
Employers choosing to provide the carryover must amend the plan before the end
of plan year from which the carryover will occur. Plan amendments must also include
the elimination of any grace period. Participants must be notified of the carryover
provision via a revised summary of plan description (SPD) or summary of material
modifications (SMM). Plan years starting in 2013 have until the end of the plan year
that starts in 2014 to amend plan documents to allow a carryover.
Other rules and implications
Employer plans may establish a lower maximum limit than $500, but it must be uniformly applied
to all eligible participants. The carryover is applicable only to Health FSAs (not to Dependent
Care FSAs). A participant’s carryover amount does not count toward $2,500 §125(i) salary
reduction contribution limit. The carryover amount can include both employer and employee
contributions.
The carryover amount is available, even if a participant does not make an election for
the next plan year. For example, if $500 remains unused at the end of the plan year,
it can be carried over for the next plan year even though the participant does not
elect Health FSA coverage in the following year. The participant will start the new
plan year with a $500 account balance. In theory, this balance could be carried over
for several years even though the participant does not elect Health FSA coverage.
Unused amounts above the carryover limits are subject to forfeiture and cannot be cashed out
or transferred to other taxable or nontaxable benefits (e.g., HSAs).
The carryover is not available if employment terminates except via COBRA (if available). Further
guidance is expected on some of the COBRA issues related to the carryover.
HSA compatibility also was not addressed in the Notice. We do know that a general purpose
Health FSA (including carryover) disqualifies an individual from contributing to an HSA, most
likely for the entire plan year.
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3. In such an event, it appears that the Health FSA might have some design options:
• Limited purpose
• Post-deductible
• Both limited purpose and post-deductible
Based on existing regulations, it does not appear that carryover amounts would be included in
nondiscrimination testing or justify a midyear election change. It is unclear whether carryover
amounts need to be reported on W-2s in box 12 as Code DD.
In theory, individuals wanting to contribute to an HSA could simply waive the carryover.
Comparison
Feature
Carryover
Grace period
Amount available after plan year ends
Up to $500
Unlimited
Duration of availability after plan year ends
Unlimited
2 months, 15 days
Use-or-Lose Rule is no longer a major
concern
Yes
No
Likely decrease in forfeitures
Yes
No
Likely increase in participation
Yes
No
Likely increase in election amounts
Yes
No
Corresponding increase in savings related
to income tax and FICA for participants
Yes
No
Corresponding increase in savings related
to FICA for employers
Yes
No
Most employers should be doing the math right now. With carryovers, will the likely
moderate decrease in forfeitures be offset by the increase in FICA savings (7.65
percent)? When you do the math, many will agree that the carryover presents an
exciting win-win proposition for both employers and employees!
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800-300-3838