IRS eases ‘Use It Or Lose It Rule’ for FSAs

An unpopular restriction on a widely-used employee benefit – the flexible spending account — was recently relaxed by the Internal Revenue Service.

Flexible spending accounts — or FSAs — allow employees to contribute pre-tax dollars from their pay to be used to reimburse eligible expenses. If the employer provides FSA plans, participating employees may establish a health-care FSA, a dependent-care FSA, or both, and make pre-tax contributions to these accounts. Participation in such arrangements, however, have carried a certain amount of risk due to the so-called “Use It or Lose It” rules.

Previously, these rules required that amounts contributed to the FSA may only be used to reimburse eligible expenses incurred during the “plan year” (a 12-month period selected by the sponsor of the FSA). To the extent that the participant incurs fewer medical expenses than his or her annual election, or fails to request reimbursement within the required time frame, amounts remaining in the FSA at the end of the plan year are forfeited.

While IRS Notice 2005-45, released May 18, does not eliminate the “Use It or Lose It” rules, it does say that unused amounts may now be carried forward and used to offset eligible expenses incurred during the first 2-1/2 months of the following plan year.

For example:

Mary elects to contribute $1,200 to her medical FSA in 2005. By Dec. 31, 2005, she has only incurred $1,000 in eligible expenses. Under the prior rule, Mary would forfeit the unused $200. Under the new rule, should Mary’s employer choose to amend the FSA plan, the $200 may be used to reimburse medical expenses Mary incurs between Jan. 1, 2006 and March 15, 2006.

The addition of this grace period is not automatic. The notice simply allows employers to amend their FSA plans to include such a grace period.

The notice also does not change the fundamental restrictions on FSA reimbursements. Only certain types of expenses may be reimbursed, unused amounts are still forfeited (albeit at a later date), FSAs cannot be cashed out or otherwise converted to compensation and amounts in one type of FSA cannot be used to reimburse other categories of eligible expenses.

Your FSA administrator is likely to contact you with information regarding how this notice will affect your FSA plan. If not, you should contact the administrator to determine if amending your plan is in your organization’s best interest.

Questions you may wish to review with your administrator include:

• Can the current administrator support the additional record-keeping requirements of this grace period?

• Will there be additional costs associated with amending your FSA plan and/or administering the grace period?

• How does your administrator recommend addressing the reimbursement of claims incurred during the grace period? The example in the notice suggests that the unused amounts from the prior year be applied first.

If, after discussing these issues with your administrator, you determine that it is appropriate to amend your FSA plan to adopt the grace period, careful consideration should be given in communicating this change to employees. Consider asking your administrator to assist you in this process.

Also be aware that if your FSA plan also utilizes a “runoff period” – a period after the end of the plan year during which claims incurred during the plan year can be submitted – you should make sure that this runoff period is long enough to accommodate the addition of the grace period. For example, if a grace period is adopted that March 15, then a runoff period ending on March 31 may not give participants sufficient time to receive and submit the documentation necessary for reimbursement.

While there is no specific deadline by which an employer must make this decision, an employer that decides to make this change must amend the plan before the end of the plan year to which the grace period will apply.

David Phillips is an associate with the firm of Concord law firm of Gallagher, Callahan & Gartrell, where he practices in the areas of taxation and employee benefits. Dana Scott, a human capital and benefits consultant with Gallagher, Callahan & Gartrell, advises clients on human resource and employee benefits issues.

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