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As if all the Health Care Reform Issues Aren’t Enough…Change to Flexible Spending Accounts

Flexible Spending Accounts (FSAs) to pay for medical expenses first came about in 1979, as employers were reducing insurance coverage on their employees in order to deal with rising insurance premiums. Here we are almost 35 years later, still dealing with rising health care costs, including companies going through the annual process of figuring out how they are going to keep their premiums in check. In recognition of this, the IRS has made yet another change to the FSA rules, this time allowing for up to $500 of unused amounts to be carried over from year-to-year.

This is actually quite a remarkable change. For years, the biggest deal about an FSA was the “use-it-or-lose-it” rule. That is, you choose at the beginning of the year how much to set aside, you have very limited reasons to change that amount during the year, and if you don’t use it all by the end of the year then your employer gets to keep the unused money. This wasn’t a case of the IRS being arbitrarily mean; the law specifically says that you can’t use an FSA to provide for deferred compensation. So if you set aside money tax-free in one year to be used in a later year, you were deferring compensation, which the law did not allow.

In 2005, the IRS started to bend the “use-it-or-lose-it” rule by ruling that an FSA could be amended to allow any amounts unused at the end of the year to be used during the first 2½ months of the following year. Their rationale was that other areas of tax law said compensation wasn’t deferred if received within 2½ months after the end of a year. This grace period was intended to remove the incentive of employees to go have “unnecessary” medical procedures done, or to stock up on medical supplies, before year-end just to avoid losing the money they had set aside.

Now the grace period has an alternative. The IRS took its rule bend from 2005 and, arguably, has now broken the “use-it-or-lose-it” rule by allowing an FSA to be amended to provide for a carryover of up to $500 to the following year. This time the rationale is that, because of the new $2,500/year cap on amounts that can be contributed to an FSA, the potential for being able to use an FSA to defer compensation is very limited. So, we can still mostly comply with the spirit of the law, even though we are allowing for a technical violation of the law. And who is going to complain? No one. It would literally take an act of Congress to overturn this little freebie that the IRS has thrown our way.

So if you want to take advantage of this new $500 carryover, here are some things you need to know:

  1. You must amend your cafeteria plan to allow it. If you don’t want to give this new  benefit to your employees because of the administrative hassle, then just don’t amend your plan.
  2. You can do the amendment for your plan year that is already in process, so that your employees don’t have to start going into scramble mode to use the money they’ve previously set aside. In fact, you have until the end of your 2014 plan year to amend your plan retroactive to the beginning of your 2013 plan year.
  3. You can provide for the $500 carryover OR the 2½ month grace period (OR neither), but not both. If you want to allow one of these “enhanced features” to your employees, the grace period will generally be more beneficial if your employees tend to elect more than $500 each for their FSA, while the carryover will be better if your employees elect $500 or less each per year.