$500 Carryover Option for FSAs
On October 31, 2013, the IRS modified the “use-it-or-lose-it” rule that applies to health flexible spending arrangements (health FSAs). See Notice 2013-71 here.
At the employer’s option, beginning as early as the current 2013 plan year, employees participating in health FSAs can be permitted to carry over up to $500 of unused health FSA contributions remaining at the end of the plan year and use them in the following plan year.
In light of this new rule, employers now have three choices in structuring their health FSAs:
1. Amend their health FSA to add this $500 carryover (as early as 2013);
2. Offer a 2 ½ month grace period to use health FSA funds after the close of the plan year;
3. Not provide for a carryover or a grace period.
The IRS said it wanted to allow employees to have more flexibility in using their health FSA contributions in light of the Affordable Care Act’s imposition of a $2,500 cap on an employee’s annual health FSA contributions. But if you are an employer considering this new $500 carryover, we caution you to make sure that adoption of the $500 carryover does not create new problems for you.
Health FSAs Can NOT Have Both A Grace Period AND a $500 Carryover
Your health FSA cannot provide for both the $500 carryover and the 2 ½ month grace period. To utilize this new carryover option, your health FSA must be amended to adopt the carryover on or before the last day of the plan year from which funds will be carried over, retroactive to the first day of that plan year (there is a special transition rule if you want to adopt the carryover for the 2013 plan year. This rule gives you until the end of the 2014 plan year to adopt the amendment for the 2013 plan year, provided your health FSA is operated consistently with this change and you inform the participants about the carryover feature). If your health FSA currently offers a grace period, you must also amend your health FSA to eliminate the grace period for that same plan year. You should beware that swapping the grace period (which could apply to the full $2,500 of health FSA contributions) for the $500 carryover after the plan year has already begun (or in some cases, even before the plan year has begun but after open enrollment has closed) may unfairly deny participants the use of health FSA dollars they have already contributed. It may also lead to confusion among your participants.
$500 Carryover Can Jeopardize HSA Eligibility For the Entire Next Year
While the IRS did specifically provide that the $500 carryover will not count against the following plan year’s employee health FSA contribution limit (which will still be $2,500), it did not create an exemption from the rule that provides that employees who participate in a general purpose health FSA in any calendar month are ineligible to contribute to a health savings account (HSA) for that calendar month. Over the past several years, many employers with general purpose health FSAs containing 2 ½ month grace periods ran into problems with this rule when they decided to follow the trend of moving to more consumer-driven health coverage options that included high deductible health plans (HDHP) and HSAs. In those cases, some of their employees who had money left in their general purpose health FSA at the start of the grace period and elected the HDHP/HSA option for the new year were penalized by being unable to contribute to their HSA for the first three months (the IRS took the position that the HSA ineligibility applied to the entire period during which the funds could be used in the general purpose health FSA, even if the employee spent the funds in the first few days of the grace period). The impact could be far worse if the $500 carryover is in place because it appears that a general purpose health FSA participant who has an amount carried over to the next year could be ineligible to contribute to an HSA for the entire next plan year (based on the current IRS approach for grace period ineligibility, as described above). Thus, if you believe that you may begin offering an HDHP/HSA option to your employees in 2015, you need to be sure the employers understand the full effect of a $500 carryover that applies to employee general purpose health FSA contributions made in the 2014 plan year.
You should talk with your legal counsel and consider the above practical limitations when deciding whether you want to allow for the carryover option or the grace period. There may be strategies available to you, such as adoption of certain limited purpose health FSA provisions, that can help ease the transition or minimize problems.
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