IRS Further Relaxes “Use-It-or-Lose-It” Rule for Health Flexible Spending Accounts

November 7, 2013

On October 31, 2013, the Internal Revenue Service issued IRS Notice 2013-71, which modifies the “use-it-or-lose-it” rule for health flexible spending accounts (“HFSAs”).  IRS Notice 2013-71 gives HFSA sponsors the option of allowing participants to roll over up to $500 of unused HFSA contributions from one plan year to the next.

Until now, the “use-it-or-lose-it” rule has required HFSA amounts to be forfeited if not spent by the end of the HFSA plan year.  In 2005, the IRS modified this rule by allowing for a 2 ½-month “grace period” after a plan year during which participants could use amounts remaining from the prior year to pay for qualified medical expenses incurred during the grace period.

Because of “the difficulty for employees of predicting their future needs for medical expenditures, the desirability of minimizing incentives for unnecessary spending at the end of a year and the possibility that lower – and moderate – paid employees are more reluctant than others to participate because of aversion to even modest forfeitures,” the IRS has decided to further relax the “use-it-or-lose-it” rule by allowing up to $500 to be carried over to the next plan year.  IRS Notice 2013-71 makes it clear, however, that plan sponsors may not provide both a “grace period” and a carryover.  Also, the carryover must be made available to all HFSA participants equally.

The good news?  Amounts rolled over into the next year will not count towards the $2,500 annual limit on employee HFSA contributions.  This example from IRS Notice 2013-71 helps illustrate this point:

Example:  Employer sponsors a Section 125 cafeteria plan and HFSA with a calendar plan year, an annual run-out period from January 1 through March 31 in which participants can submit claims for expenses incurred during the preceding plan year, and an annual open enrollment season in November in which participants [may] elect a salary reduction amount (not to exceed $2,500) for the following plan year.  The plan is timely amended to provide for a carryover that allows all participants to apply up to $500 of unused HFSA amounts remaining at the end of the run-out period to … expenses incurred at any time during [the new] plan year.  The plan does not provide for a grace period or employer contributions. NOTE: a “run-out period” is not the same as a “grace period.”

In November 2014, Participant A elects a salary reduction amount of $2,500 for 2015.  By December 31, 2014, A’s unused amount from the 2014 plan year is $800.  On February 1, 2015, A submits claims and is reimbursed with respect to $350 of expenses incurred during the 2014 plan year, leaving a carryover on March 31, 2015 (the end of the run-out period) of $450 of unused HFSA amounts from 2014.  The $450 amount is not forfeited; instead, it is carried over to 2015 and is available to pay claims incurred in that year, so that $2,950 (that is, $2,500 + $450) is available to pay claims incurred in 2015.  A incurs and submits claims for expenses of $2,700 during the month of July 2015, and does not submit any other claims during 2015.  A is reimbursed with respect to the $2,700 claim, leaving $250 as a potential unused amount from 2015 (depending upon whether A submits claims during the 2015 run-out period in early 2016).

This HFSA satisfies the $500 carryover rules.

The new rule of IRS Notice 2013-71 is optional.  Plan sponsors that wish to provide the $500 carryover from 2013 to 2014 will need to have their HFSA plan documents amended by the end of the 2013 plan year (that is, by December 31, 2013 for calendar-year plans).  The carryover rule may also be added in the future so long as the amendment is adopted on or before the last day of the plan year from which amounts will be carried over and may be effective retroactively to the first day of the plan year.  The amendment must also eliminate any previously existing grace period.