In new guidance issued late last week (here), the IRS tackled a long-standing issue with cafeteria plans: the requirement that all dollars be used by the end of the plan year or be forfeited. Employees can now be allowed to carryover up to $500 remaining in a health FSA account at the end of the year and use it at any time during the following year. But there are some conditions and limitations, and it's not clear that this approach will be ideal for all plans. Here's what you need to know.
Optional. Employers are not required to add the carryover option to their health FSA plans. But if they do want to add the option, they must timely amend their plans and make sure they meet the other conditions for offering the carryover. Also, employers are not required to allow carryover of the full $500. They could specify a lower carryover amount.
Relationship to $2,500 Cap. Amounts carried over from one plan year to the next under this guidance do not count against the $2,500 cap on salary reduction contributions for the carryover year. So, for example, an employee could carryover $500 from the 2014 plan year into the 2015 plan year and make a $2,500 salary reduction election for the 2015 plan year, giving the employee a total of $3,000 available during the 2015 plan year.
Grace Period. A plan cannot offer both the carryover option and a grace period option. It must be one or the other. This leads to a key decision point for employers, particularly employers that currently offer a grace period: Is it better to offer the grace period or the carryover? On one hand, the amount available during the grace period is unlimited, so an employee could potentially use up to $2,500 (or more, if there are employer contributions) from the prior year on expenses incurred during the grace period. On the other hand, the grace period only allows for reimbursement of expenses incurred during the first 2-1/2 months of the year, while the carryover amount can be used for expenses incurred at any time during the year. It won't always be clear which option is better.
Ordering Rules. The amount available for carryover is the amount remaining in an employee's account at the end of the plan year after reimbursement of claims submitted during the run-out period at the end of the year. This means a plan offering the carryover will need to implement ordering rules for determining which claims will be processed first and from which year's dollars the claims will be reimbursed. For example, a plan might provide that claims will be processed in the order in which they are submitted and will be paid first from dollars contributed in the current year before they are applied against the carryover amount.
Example. A plan allows for carryover of up to $500 and also provides for a 90-day run-out period. Claims will be processed in the order in which they are submitted and reimbursed from current-year dollars before prior-year dollars. A participant has $800 remaining in her account at the end of the 2014 plan year, and she elects to contribute $2,500 to her account during the 2015 plan year. She incurs a $2,700 claim in January 2015 and immediately submits it for reimbursement. In February 2015 (during the run-out period), she then submits a claim for reimbursement of $700 in expenses incurred during the prior plan year. The plan reimburses the claims as follows: (1) The $2,700 claim submitted in January is reimbursed first from 2015 contributions ($2,500) and second from carryover amounts ($200). (2) The $700 claim submitted in February must be reimbursed from 2014 contributions remaining in the participants account at year-end, because the claims were incurred during 2014. But the participant has already used $200 of that year-end balance under the carryover rule to reimburse the January claim, so the amount available to reimburse run-out period claims is reduced from $800 to $600. Only $600 of the $700 claim submitted in February 2015 will be reimbursed, and there will be no further carryover amounts available during 2015.
Amendment Timing. The general rule is that a cafeteria plan must be amended on or before the last day of the plan year in order to allow amounts to carryover from that year to the next. However, under a special rule for the 2013 plan year, the plan may be amended to add the carryover option for the 2013 plan year, so long as the amendment is adopted no later than the end of the plan year beginning in 2014. For example, if a calendar-year plan wants to add the carryover option for the year ending December 31, 2013, the amendment must be adopted by December 31, 2014. Also, because a plan cannot offer both a grace period and a carryover option, plans that currently offer a grace period but want to switch to the carryover must be amended to eliminate the grace period by no later than the end of the plan year from which amounts may be carried over.
Impact on HSA Eligibility. Employers that offer a high-deductible health plan so employees can make health savings account contributions will need to think through the impact of the carryover rule on HSA eligibility. Because carryover amounts are available throughout the plan year to which they are carried over, a participant who carries over dollars into a general purpose health FSA for a plan year will be disqualified from making an HSA contribution for that entire plan year, even if there are no new salary reduction contributions to the health FSA during that year. Further guidance is expected from the IRS on how the carryover rules will related to HSA eligibility.
Bottom Line. Although the carryover rule is generally favorable to employees, the decision whether to offer the carryover option may be more complex than it first appears. Employers are encouraged to think through the issues carefully before deciding on a course of action.