(This article was updated on November 11, 2013 to add several practical considerations and additional information.)
The IRS issued Notice 2013-71 October 31, 2013, modifying the longstanding “use-it-or-lose-it” rule for health flexible spending arrangements (HFSAs). Plan sponsors now have the option of amending their cafeteria/HFSA plan documents to allow HFSA participants to carry forward—rather than forfeit—up to $500 of unused amounts remaining in the HFSA at year-end. Plans that do not currently include a grace period could implement the new carryover provision from the 2013 to the 2014 plan year. Note that a written plan amendment is required to adopt the new carryover provision. The IRS Notice does not address whether the new $500 carry over provision is available for limited purpose HFSAs. Employees in high deductible health plans (HDHPs) cannot participate in regular HFSAs, but employers can allow them to participate in limited purpose HFSAs.
Plan Cannot have Both Carryover Option and Grace Period
This carryover option is an alternative to the grace period allowed under current law. A plan can have either the carryover or the grace period or neither. Under current law, plan sponsors have discretion to allow HFSA participants a grace period of up to two and a half months after the end of the plan year. Qualified expenses incurred during this grace period may be reimbursed from HFSA contributions for the prior year.
Caveat: Plans that currently have a grace period for the 2013 plan year (allowing reimbursement in 2014 during the grace period after the end of the 2013 plan year) might not be able to implement the carryover provision for the 2014 plan year. Notice 2013-71 notes that a plan sponsor’s “ability to eliminate a grace period provision previously adopted for the plan year in which the amendment is adopted maybe subject to non-Code legal constraints.” See additional information below in the section on Additional Details on Written Plan Amendments.
Carryover Option does Not Affect $2500 Salary Reduction Maximum or Use of a Run-Out Period
If a plan allows the new carryover of up to $500, this does not affect the maximum amount of salary reduction contributions a participant is permitted to make the following plan year under Code section 125(i). This amount remains at $2,500 (adjusted for inflation after 2012). Thus, a plan participant who carries over $500 from the 2013 plan year to the 2014 plan year may also make a $2,500 salary reduction election for the 2014 plan year.
A practical note: The $500 carryover provision is not cumulative. That is, an employee who carries over $500 from year 1 to year 2 does not have up to $1000 to carry over from year 2 to year 3, and $1,500 from year 3 to year 4. The new carryover provision allows a maximum carryover amount of only $500 per year, regardless of carryovers from prior years or account balance in the current year.
The new carryover option also does not affect the ability of a health FSA to use a run-out period. During a run-out period (which many HFSAs currently allow), the HFSA can apply unused funds from the prior plan year to pay qualified expenses that were incurred during the prior plan year, so long as the expenses are submitted for payment within the run-out period. (The run-out differs from the grace period and the carryover because under these two provisions funds from the prior plan year are used to reimburse expenses incurred in the following plan year.)
A practical note: If an HFSA plan that includes a run-out period is amended to add a carryover provision, the carryover is done at the end of the run-out period, not at the end of the prior plan year. That is, claims submitted during the run-out period for expenses incurred during the prior plan year are paid first. Then if at least $500 is left from the prior year’s funds, up to $500 of that amount may be carried forward.
Implementing New Carryover Provision Requires Written Plan Amendment
A plan sponsor that wants to implement the new carryover provision must adopt a written amendment to its cafeteria/HFSA plan. Generally, the amendment must be adopted on or before the last day of the plan year from which amounts may be carried over and may be effective retroactively to the first day of that plan year; however, plan years that begin in 2013 have an additional year in which the amendment can be adopted. Such amendment may be adopted any time on or before the last day of the plan year that begins in 2014. Additionally, the plan must operate in accordance with the guidance under Notice 2013-71 and must notify participants of the carryover provision.
Some Important Practical Points
Notifying employees. Employers who decide to offer the new carryover option should notify eligible employees and plan participants as soon as possible of their decision and also explain how the carryover works. This could be in stand-alone communications as well as in the summary plan description (SPD).
Application to “limited purpose HFSAs,” Notice 2013-71 does not address this, but the carryover provision probably is not applicable to limited purpose HFSAs that are associate with high deductible health plans (HDHPs). This is because individuals cannot make contributions to their HSAs (or have contributions made on their behalves) if they are participating in other non-HDHP group health plans. A participant who has a carryover amount in the limited purpose HFSA might be considered to be participating in a non-HDHP group health plan. Additional guidance from the IRS would be welcomed.
Employer risk. The carryover does not increase the employer’s risk because by the end of the plan year each participant has already paid the full amount for the year. The carryover provision just allows a participant to carry forward up to $500 of the amount the participant has already contributed.
Employer cost. The carryover might, however, increase an employer’s cost of its HFSA. Many employers currently use forfeitures to offset their administrative costs. Adopting a carryover provision results in lower forfeitures, which also means incerased administrative costs. Additionally, if an employee carries over an amount from 2014 to 2015, but does not make a salary reduction election for 2015, the employee will still have an account in 2015, and the employer probably must pay a monthly adminisrative fee for each account.
Limitations: The same carry over limit must apply to all plan participants. Also, a plan cannot allow participants to cash out the carryover amount or to convert it to any other taxable or nontaxable benefit (other than “qualified benefits” that can be reimbursed under the HFSA). This means that carryover amounts could not be used to pay the premiums for individual coverage, since this is not an eligible expense under an HFSA.
Additional Details on Written Plan Amendments
Plans that do not currently include a grace period may be amended to allow the new carryover provision from the 2013 to the 2014 plan year. However, plans that currently have a grace period for the 2013 plan year (allowing reimbursement in 2014) might not be able to implement the carryover provision until the 2015 plan year. Notice 2013-71 provides in part that a cafeteria plan that incorporates a carryover provision may not also provide for a grace period in the plan year to which unused amounts may be carried over. If a plan permits amounts that were unused in one plan year (e.g., 2013) to be carried over to the following plan year (2014), the plan is not permitted to provide for a grace period that occurs in that following plan year (2014). The plan could have had a grace period for 2012 that occurred at the beginning of 2013, and could allow the carryover from 2013 to 2014.
The Notice also provides that if a plan has provided for a grace period and is being amended to add a carryover provision, the plan must also be amended to eliminate the grace period provision by no later than the end of the plan year from which amounts may be carried over. Thus, for example a plan that currently includes a grace period, but wants to switch to allowing a carryover instead, must be amended to eliminate the grace period by the end of 2013. As noted above, Notice 2013-71 cautions that “the ability to eliminate a grace period provision previously adopted for the plan year in which the amendment is adopted may be subject to non-Code legal constraints.” Additional clarification from the Service would be appreciated, but perhaps an example would be a participant in 2013 who plans to have lasik surgery in January 2014 and to use funds from both 2013 and2014 to pay for the lasik surgery. Since the grace period provision was in effect when the participant made his/her 2013 salary reduction election, such participant relied on it, and on being able to use 2013 and 2014 amounts during the grace period (January 1-March 15, 2014) to pay for the surgery.
Reasons for the Change to the “Use-it-or-Lose-it” Rule
The IRS Press Release says:
” Today’s action directly responds to public comments invited by the Treasury Department and the IRS” in Notice 2013-40. That Notice clarified that the $2,500 limit on salary reduction amounts applied as of the first day of the 2013 plan year, not as of January 1, 2013. According to the IRS Press Release, “An overwhelming majority of feedback from individuals, employers, and others requested that the use-or-lose rule for health FSAs be modified. Comments pointed to the difficulty for employees of predicting future needs for medical expenditures, the need to make FSAs accessible to employees of all income levels, and the desire to minimize incentives for unnecessary spending at the end of the year.”
IRS also issued a one-page Fact Sheet.