Posted on November 4, 2013

New Carryover Option for FSAs

The IRS has modified the "use-or-lose" rule for health flexible spending arrangements (FSAs) to give employers the option to allow participating employees to carry over up to $500 of unused amounts remaining in their health FSAs at year end. Previously, any amounts that weren't used by year end or the end of an optional "grace period" of up to 2 1/2 months would be forfeited.

Why the change?

The original "use-or-lose" rule was adopted to prevent employees from using a health FSA to defer compensation by accumulating salary reduction amounts. A variety of reasons led the IRS to change this rule:

* The new $2,500 FSA limit helps prevent large accumulations, making the "use-or-lose" rule less necessary
* Employees often have difficulty predicting their future medical expenses
* The current rule can cause unnecessary spending at the end of the plan year or grace period
* Changing the rule eases FSA administration

How much can be carried over?

Under the new guidance, an employer's cafeteria plan can allow employees to carry over up to $500 of any unused amount in a health FSA to the plan year immediately following. The carryover amount may be used to reimburse medical expenses incurred at any time during the plan year to which it is carried over.

The plan can specify an amount lower than $500 as the maximum carryover amount, or can decide not to allow any carryover at all. Whatever decision the employer makes, the plan must allow all employees to carry over the same maximum amount.

Is the $2,500 plan limit affected?

The carryover doesn't count against or otherwise affect the next year's $2,500 salary reduction limit, as indexed for inflation. Any unused amount in excess of $500 will be forfeited under this modified "use-or-lose" rule.

Can an employer's plan use both a grace period and a carryover?

A cafeteria plan that is amended to include a carryover provision may not also include a grace period in the plan year to which unused amounts may be carried over (for example, no grace period is allowed in 2015 if unused amounts can be carried over to 2015). If a plan with a grace period is being amended to add a carryover provision, the plan amendment must eliminate the grace period by no later than the end of the first plan year from which amounts may be carried over.

Can employees receive any unused amounts in cash?

One rule has not changed: a cafeteria plan may not allow unused amounts in a health FSA to be cashed out or converted to any other taxable or nontaxable benefit.

How do employers take advantage of this change?

To take advantage of the carryover option for a plan year, the employer must change its cafeteria plan to adopt a carryover provision on or before the last day of that plan year. If that is done, the amendment may be made effective retroactively to the first day of that plan year. However, the notice also provides that a plan may be amended to adopt the carryover provision for a plan year that begins in 2013 at any time on or before the last day of the plan year that begins in 2014.

For more information, visit the IRS website.

Source: American Payroll Association, IRS Notice 2013-71