IRS Modifies the Flexible Spending Arrangements “Use It or Lose It” Rule

Patricia K. Keesler

Benefits Law Group

June, 2005

 

On May 18, 2005, the IRS issued Notice 2005-42, changing its position on the “use it or lose it” rule under Flexible Spending Arrangements. The old rule required employees who participated in a Flexible Spending Arrangement to forfeit any amounts left in their accounts at the end of the plan year. Only expenses actually incurred during the plan year could be reimbursed from the participant’s account. Under the new ruling, for 2005 and later plan years, unused amounts allocated to Flexible Spending Arrangements may be used after the end of the year for expenses incurred in the first 2-1/2 months of the following plan year. Therefore, now, only amounts not used by the end of the 2-1/2 month grace period need be forfeited. 

The new rule allows health care spending account plan participants look at their medical spending as of the end of the year and plan to use remaining account balances for medical expenses prospectively during the next 2-1/2 months. It broadly expands the ability of participants to plan their medical spending and avoid year-end spending rushes to avoid forfeiture.

The rule may also be applied to dependent care assistance plans, though the impact for such plans is less, because contributions are typically paid out as benefits within a week or two of the date they are contributed.

To take advantage of the new rule, an employer must amend its flexible spending account plan before the end of the 2005 plan year. The amendment is not mandatory but without an amendment, no medical reimbursement account balances can be used in the following year. If an employer chooses to implement this new rule, the following conditions and limitations will apply:

·       The grace period must apply to all participants in the cafeteria plan.

·       The grace period must not extend beyond March 15 (for calendar year plans).

·       The end of the grace period is the last day expenses can be incurred, but a run-out period following the end of the grace period is still permitted.

·       During the grace period, the plan may not permit unused benefits or contributions to be cashed out or converted to any other benefit.

·       Unused accounts relating to a particular qualified benefit may only be used to pay or reimburse expenses incurred with respect to that particular qualified benefit. For example, unused amounts in a health flexible spending arrangement may not be used to pay or reimburse dependent care expenses.

·       The amendment must be communicated to employees.

The rule is likely to increase participation in Flexible Spending Arrangements. Employees will like the new rule as it will reduce forfeitures. Even if all the new rule does is delay the mad rush to spend the money remaining in their accounts, just the delay from late December to mid-March will be a most welcome change.