New Health FSA Carryover Rule Poses Tough Choices for Plan Sponsors

By Jeff Belfiglio  

Davis Wright Tremaine LLP, Bellevue, WA

The IRS has announced new, long-requested relief from the "use
it or lose it" rule that will allow health flexible spending
account (FSA) participants to carry over up to $500 of unused
contributions to the next plan year if this feature is adopted by
the plan sponsor. The catch is that an FSA cannot have both a
carryover and a grace period, which means many plan sponsors will
need to make a difficult decision as to which feature is best
suited for their plan. The timing of the rule also poses problems
if a plan sponsor wants to implement changes for the current 2013
plan year to allow carryovers to the 2014 plan year.

Current rule and grace period
 The current rule is the familiar
"use-or-lose" rule requiring that unspent contributions in an FSA
at the end of a plan year be forfeited. In 2005, the IRS created
the "grace period" exception that allows any unused amounts to be
spent down during the 2  1/2 months following the plan year.
Many FSA plans have adopted a grace period. Under the Affordable
Care Act, health FSAs are now limited to $2,500 per year. In light
of the new limit, the IRS announced in 2012 that it would consider
modifying the use-or-lose rule.

New carryover benefit. In Notice 2013-71,
2013-47 I.R.B. 532, the IRS modified the existing rules to allow a
health FSA (but not a dependent care account) to adopt a carryover
provision. The health FSA carryover allows up to $500 in unspent
contributions (after claims submitted in the run-out period) to be
carried over after the end of a plan year and used any time in the
next plan year. The plan may adopt a carryover limit of less than
$500, but the same limit must apply to all participants. The
carryover does not affect the amount a participant can elect for
the next plan year, so effectively up to $3,000 can be available,
but the carryover is available even if no contributions are made
the next year.

The catch. Notice 2013-71 states that a
health FSA cannot have both a carryover and a grace period
applicable to the unspent amounts in a given year. Thus, a plan
with a grace period must eliminate it in order to adopt the
carryover. This can pose a difficult choice for an employer. On the
one hand, the grace period allows more than $500 to be carried
over, but only for a limited time. On the other hand, the carryover
is capped at $500 but can be used up over an entire year. Some
participants will be better off under one or the other. Any plan
change will need to be clearly explained. If the FSA does not have
a grace period, the sponsor only needs to weigh the administrative
cost and loss of forfeitures from adding the carryover.

An example in the Notice shows that the carryover can be
indefinite, continuing from year-to-year until it is used up or
forfeited when the participant terminates. For example, a
participant could carry over $500 from 2014 into 2015 and stop
contributing to the FSA. If he/she only submits $200 in 2015, $300
would carry over to 2016, and so on. This extended spend-down
feature may also deter sponsors from switching from the grace
period to the carryover.

Replacing a grace period with a carryover provision may create
another unintended consequence. The grace period can make an FSA
participant who moves to an HSA-based plan ineligible to contribute
the to the HSA for three months. A rule that allows a new HSA
participant to contribute the full year's amount in the first year
of eligibility, even if eligible for only part of the year,
alleviates the effect of the grace period. But since the carryover
is available the entire following year, it presumably would prevent
HSA contributions for the entire year. Thus, such a participant in
a plan with a carryover would have to be sure to use up the entire
account by the end of the year before moving to an HSA plan, unless
the IRS gives us additional guidance.

Implementation hurdles. The IRS Notice poses
some implementation issues. Simply adding the carryover requires an
amendment by the end of the year from which amounts may be carried
over, but there is an extension for 2013, under which the amendment
deadline is the last day of the plan year beginning in 2014. If the
plan has a grace period, it must be eliminated by the end of the
plan year from which amounts may be carried over-with no extension
for 2013. Thus, a plan with a grace period that wants to change to
the carryover for 2013 account balances will have to act by the end
of this year-and explain the change to participants who had been
expecting the grace period at the end of 2013. Action in 2014 seems
more likely as employers ponder their choices.

Action items.  

  •   Review the operation of your cafeteria plan and consider
    whether a carryover provision is well-suited to the plan and your
    general health plan (such as whether you are converting to an
    HSA-based health plan).
  •   Even if the employer will wait until 2014 to adopt the
    carryover, consider whether participant communications for 2014
    open enrollment (underway now in some plans) should explain that
    the grace period may be replaced by a carryover at the end of

For more information, in the Tax Management Portfolios, see
Cowart, 389 T.M.
, Medical Plans - COBRA, HIPAA, HRAs and
Disability, and in Tax Practice Series, see ¶5940, Cafeteria

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