Category Archives: Health FSA

New Cafeteria Plan Guidance Eases Transitions to Exchange Coverage

IRS Notice 2014-55, issued September 18, 2014, permits two new types of mid-year changes in cafeteria plan elections (other than health flexible spending account elections) that will enable employees to drop employer group coverage in favor of individual coverage offered on state and federally-facilitated health exchanges (collectively, “the Exchange.”)  Making that transition primarily will appeal to employees with household incomes in ranges that qualify them for financial assistance on the Exchange, in the form of premium tax credits and cost sharing.  Those ranges are between 100% and 400% of federal poverty level in states that have not expanded Medicaid, and between 138% and 400% of federal poverty level in states that have expanded Medicare.

Recap of Existing Change in Status Rules

Under existing cafeteria plan regulations, a participant may make a mid-year change in their plan elections only in the event of a “change in status,” and only to the extent that the election change is both “on account of” and “corresponds with” the change in status.  This latter requirement is referred to as the “consistency rule.”  An example of a change in election that satisfies the consistency rule is removing a spouse from coverage as a result of a change in status that is a legal separation or divorce.  By contrast, the participant dropping his or her own coverage in that situation would not satisfy the consistency rule.

Existing regulations set forth a finite list of changes in status that trigger the right to a mid-year cafeteria plan election.  The list does not currently include a change in employment status – such as a transition from full-time to part-time status – that is not accompanied by a loss of group health plan eligibility. In addition, under special enrollment rights that were introduced with HIPAA, employees may enroll in their employer’s plan in the event they lose other coverage (for instance, through exhausting COBRA coverage), may add to their coverage a dependent newly acquired through birth, marriage, or adoption, and may make mid-year cafeteria plan changes that are consistent with these events.  HIPAA’s special enrollment rights do not contain provisions that relate to availability of individual coverage on the Exchange.

Please note that references below to “changing cafeteria plan elections” may more accurately be described as revoking an election to make pre-tax salary deferral elections towards the purchase of group health premiums.

Notice 2014-55

Effective immediately, although at the option of employers, Notice 2014-55 permits mid-year cafeteria plan election changes in two different situations that are related to Exchange coverage.

The first situation applies when an employee who has been classified as full-time for ACA coverage purposes (averaging 30 or more hours of service per week) has a change in status which is reasonably expected to result in the employee averaging below full-time hours, without resulting in a loss of their group health coverage.  Under the look-back measurement method, as set forth in final employer shared responsibility regulations, an employee who averages full-time hours during an initial (following hire) or standard (ongoing) look-back measurement period generally will be offered coverage for the entire related initial or standard stability period (and associated administrative period) without regard to the actual hours worked during the stability period, such that a schedule reduction would not impact coverage.

Now, under Notice 2014-55, full-time employees whose average weekly hours are “reasonably expected” to remain below 30 – and whose reduced earnings may now qualify them for premium assistance on an Exchange, or increased assistance –  may revoke group coverage for themselves and covered dependents, provided it is for the purpose of enrolling in Exchange coverage or other “minimum essential coverage” that will take effect no later than the first day of the second month following the revocation.   (Minimum essential coverage is not limited to exchange coverage and may, for instance, include group health coverage offered by a spouse’s employer.)  Employers may rely on employee’ representations regarding the purpose of the election change.  Changes to health FSA elections are not permitted in this situation.

The second situation has two variations.  The first applies when an employee has special Exchange enrollment rights, including as a result of marriage, birth or adoption.  Similar to HIPAA special enrollment rights, these permit purchase of Exchange coverage outside of Exchange open enrollment. The second applies under a non-calendar year cafeteria plan when an employee wants to enroll in Exchange coverage during the Exchange open enrollment period, effective as of the first of the following calendar year.

In either instance an employee may prospectively revoke group health coverage for him or herself and family members, provided it is for the purpose of enrolling in Exchange coverage that will take effect no later than the day immediately following the last day of the original coverage that is revoked.  Employers may rely on employee’ representations regarding the purpose of the election change.  Changes to health FSA elections are not permitted in this situation.

Plan Amendments and Effective Dates

The IRS intends to amend cafeteria plan regulations to reflect the guidance in Notice 2014-55.  Employers may rely on the terms of the Notice until new regulations issue.

Employers who want to incorporate the new election changes into their cafeteria plans must amend their plan documents in order to do so.   Employers who put the changes into effect between now and the end of 2014 may amend their plan documents any time on or before the last day of their 2015 plan year (December 31, 2015 for a calendar year plan).  The amendment may be retroactive to the date the change went into effect, provided that participants are informed of the amendment and provided that, in the interim, the employer operates its plan in accordance with Notice 2014-55, or with subsequent issued guidance.

Employer Shared Responsibility Considerations

As mentioned, the first permitted change primarily relates to applicable large employers who use the look-back measurement period to identify full-time employees.  To minimize “pay or play” liability, these employers should continue to monitor, over subsequent measurement periods, the average hours worked by employees who migrate to Exchange coverage, and offer affordable, minimum value coverage over corresponding stability periods to those whose hours average 30 or more per week, or 130 or more per month.

Interestingly, this portion of Notice 2014-55 refers to individuals who were “reasonably expected” to average 30 or more hours of service prior to the change, but who are “reasonably expected” to average below that after the change.  This “reasonably expected” language  – which implies a measure of employer discretion – appears in the final shared responsibility regulations only in connection with assessment of an employee’s likely status (full-time, part-time, seasonable or variable hour) upon initial hire.   After an employee has remained employed throughout an entire standard stability period (which generally corresponds to the plan or policy year), he or she is an “ongoing employee” and his or her status as full-time or not full-time is determined solely based on average hours worked over the preceding look-back measurement method, or, under the “monthly” measurement period, over the preceding calendar month.  In other words, employer discretion is removed from the ongoing measurement process.  Now, it is reintroduced by Notice 2014-55 in the limited context of a schedule reduction during a stability period.

If the second permitted change is adopted by an applicable large employer, presumably that employer will continue to monitor employees who have migrated to the Exchange using the measurement method under which the employee previously qualified for an offer of group health coverage.

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Filed under Affordable Care Act, Benefit Plan Design, Cafeteria Plans, Covered California, Employer Shared Responsibility, Federally Facilitated Exchange, Health Care Reform, Health FSA, Health Insurance Marketplace, PPACA, State Exchange

Implementing the Health FSA Carryover: Tips and Traps

The IRS recently issued guidance modifying the “use it or lose it” rule, which has long been the most unpopular feature of health flexible spending accounts (health FSAs) commonly offered under a Section 125 cafeteria plan.

As a result of the change, set forth in Notice 2013-71,  individuals who participate in health FSAs, and who have not used their full budget of deferrals by the end of a given plan year may carry over up to $500 in unused funds to the next plan year.  (This discussion assumes a Sec. 125 cafeteria plan with the same plan year as the health FSA.)

Even if an employee carries over the full $500 amount, he or she may elect to defer the maximum amount currently permitted, $2,500, such that a health FSA may reimburse up to $3,000 in qualifying medical expenses in a given plan year (that, by necessity, follows a plan year in which no more than $2,000 in expenses were reimbursed).

Employers are eager to make use of this new feature, as the possibility of forfeiting even a small amount of hard-earned wages has kept significant number of employees away from health FSAs for years.  However there are some tips and traps that employers should consider before implementing the new plan feature.

  • Make a Choice.  First, an employer whose health FSA currently includes a grace period cannot implement the carryover feature alongside a grace period.  It is an “either or” choice.
    • A grace period is a period of up to 2 ½ months following the end of a plan year, during which prior year amounts may be used to reimburse expenses incurred during the grace period portion of the new plan year.
    • The main advantage of the grace period is that the full health FSA budget may be used within the grace period, whereas the carryover is limited to $500 (and employers may set a lower level if desired).   On the other hand, the grace period does not eliminate the hurried spend-down that occurs at the end of a cafeteria plan year, it just postpones it slightly.
    • By contrast, the carryover amount (up to $500) can be used at any time in the following cafeteria plan year and even in subsequent plan years, if no medical expenses require it be used in the interim.  Example 4 in Notice 2013-71 describes an instance in which $600 in unused funds from the 2014 calendar plan year, after reduction by $100 to meet the maximum carryover rule, is used to reimburse medical expenses in 2016.  Thus the carryover eliminates the spend-down scramble, but only for amounts up to $500.
    • Note that you do not need to eliminate a claim run-out period, if your plan includes one.  A claim run-out period is period following the end of a plan year, during which expenses incurred in the preceding plan year may be reimbursed using prior year amounts.  Teaming the claim run-out period with a carryover (or a grace period) requires some reimbursement ordering rules, which are discussed below under “Sequence Your Reimbursement Buckets.”
  • Timing is Everything.  For calendar year cafeteria plans, it is probably too late in the year to replace a grace period with a carryover, because employees may have scheduled procedures for after the first of the year that exceed $500 in out-of-pocket costs for the participant.
    • Because employees may have acted (or failed to act) in reliance on the grace period remaining in place, legal principles of “equity” and contract law would prevent employers from removing the feature at such a late date.  (The IRS Notice specifically references “non-Code legal constraints” that would apply; a similar concept is the “anti-cutback” rule applicable in the retirement plan sphere.)
    • Employer flexibility in this area may exist, including under non-calendar year plans, and even for calendar year plans depending on the number of participants in the health FSA and on participants’ forfeiture history.  If forfeitures consistently have been below $500 (which typically is the case), then dropping the grace period in favor of the carryover would allow employees additional time to spend the funds on medical expenses.
    • Employers must also be mindful of deadlines set forth in Notice 2013-71 for amending their cafeteria plans in relation to the carryover rule.  Amendments simply to add a carryover feature generally must be made before the last day of the plan year from which amounts are carried over.  However, only for amendments to add a carryover feature effective for the 2013 plan year (without eliminating a grace period), the amendment may be made by the last day of the 2014 plan year.  Amendments to remove a 2013 grace period (occurring early in 2014) must also be made by the last day of the plan year from which amounts may be carried over, retroactive to the first day of the plan year, but no transition relief is offered.  Therefore, an amendment to remove a grace period from the 2013 plan year, separately or in exchange for a new carryover feature, must be made by the end of the 2013 plan year, subject to the timing concerns raised above.
  • Communicate and Document.  A health FSA is an employee welfare benefit plan subject to ERISA documentation and disclosure duties.  The Notice requires plan sponsors that wish to add the carryover feature, either on its own, or in place of a grace period, to amend their cafeteria plan documents accordingly.  Plan amendments that make a material change to the contents of a cafeteria plan document must in turn be communicated to participants in the form of a written summary.  (Note:  generally this rule applies in the context of Summary Plan Descriptions (SPDs), and Summaries of Material Modifications (SMMs) to same.  However it is not uncommon for cafeteria plan documents, including health FSA components to be set forth in a single plan document without any abbreviated SPD.)
    • For a plan amendment simply adding a carryover feature, the written summary of the change must be furnished within 210 days after the end of the plan year in which the change was adopted.
    • For a plan amendment replacing a grace period with a carryover, a much shorter deadline applies:  the change must be communicated to participants in writing within 60 days after the date the employer adopts the change.

In either event, however, employers should try to provide the written summary of the change to employees as promptly as is possible, because the change likely will impact their health FSA spending before the mandatory notice periods have expired.

  • Sequence Your Reimbursement Buckets.  For your cafeteria plan to run smoothly you need to adopt “ordering rules” for reimbursing medical expenses.  It may be helpful to think of unused health FSA deferrals from the prior year as one “bucket” from which medical expenses may be reimbursed, and the new/current plan deferral amount as another “bucket.”  Important Note:  if your plan includes a claim run-out period, you will not know how much is in your “carryover” bucket until the claim run-out period has expired.  The carryover bucket can never hold more than $500.
  • One Possible Ordering Sequence:
    1. Apply prior year’s unused health FSA balance first to reimburse prior year expenses submitted during the claim-run out period.
    2. At the end of the claim run-out period, funds remaining in the prior year’s unused health FSA “bucket” are treated as follows:
      • Up to $500 remains in the bucket, which is now a carryover bucket.
      • Amounts exceeding $500 are forfeited.
  • Alternative Sequence.  The Notice also permits use of this alternative sequence:
    1. Apply current year unused health FSA balance first to claims incurred in the current plan year.  (Remember that under the uniform coverage rule, the maximum health FSA reimbursement budget elected by an employee is available to reimburse expenses as of the first day of a plan year, without regard to actual employee salary deferrals under the health FSA.)
    2. Apply prior year’s unused health FSA balance only after exhaustion of current year amounts.  Prior year unused amounts used to reimburse a current year expense (a) reduce the amounts available to pay prior plan year expenses during a claim run-out period, while applicable; (b) must be counted against the permitted carryover of up to $500, and (c) cannot exceed that maximum amount.

In either instance, current year health FSA funds may only be used to reimburse claims incurred in the current plan year, (except to the extent they remain unused at the end of a claim run-out period and are carried over to a subsequent plan year).

  • Beware of HSA Complications.  Tax-advantaged contributions to a Health Savings Account (HSA) may not be made by or on behalf of an individual who has coverage (as a participant or dependent) under a group health plan other than a high-deductible health plan (HDHP) (“disqualifying coverage”).  Eligibility under a health FSA that permits reimbursement of all expenses for medical care as defined in Code Section 213(d) is disqualifying coverage.  Coverage under a health FSA whose reimbursements are limited to dental and vision expenses, and or to other medical expenses incurred after the HDHP deductible amount is met, is not disqualifying coverage.  Notice 2013-71 does not address how the carryover feature impacts HSA eligibility.  Two possible approaches that representatives of the Groom Law Group informally have discussed with the IRS include restricting carryovers to a limited purpose health FSA, or permitting participants in general purpose health FSAs to opt out of participation in the health FSAs for years in which they want to preserve eligibility under an HSA arrangement.  Until further guidance is issued employers should assume that a participant who has a carryover balance under a general purpose health FSA, and his/her eligible spouse and dependents, will not be able to contribute to a health FSA while the carryover balance is available.

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Significant Transition Relief for $2,500 Health FSA Limit

In Notice 2012-40 the IRS has provided meaningful transition relief on the effective date of the $2,500 annual spending limit, for employers whose health flexible spending arrangements (“health FSAs”) follow a fiscal year.   Most significantly, it makes clear that employers with fiscal year health FSAs may keep higher reimbursement limits in effect through the end of their 2012-2013 plan year, and that all employers may adopt retroactive amendments to impose the $2,500 limit at any time before December 31, 2014.

Currently the tax code does not impose a dollar limit on reimbursements under a health FSA.  The Affordable Care Act limits annual reimbursements – for the first time – to $2,500, effective for taxable years beginning after December 31, 2012. Specifically, cafeteria plans must provide that an employee “may not elect for any taxable year” to make salary reduction contributions in excess of $2,500.  As individuals are calendar year taxpayers, it was assumed that “taxable year” meant the calendar year, and thus that the $2,500 limit went into effect January 1, 2013.  This in turn generated confusion on applying the limit over a fiscal year that bridged that date.  The Notice resolves this matter, and provides additional guidance as outlined below:

  •  The term “taxable year” refers to the plan year of the cafeteria plan, not the individual participant’s tax year.
    • This means that reimbursement budgets that exceed $2,500 can remain in effect for a plan year beginning any time in 2012, including a December 1, 2012 – November 30, 2013 plan year.  The $2,500 dollar limit goes into effect for plan years beginning after December 31, 2012, meaning all calendar year plans as of January 1, 2013, and fiscal year plans beginning February 1, 2013 and subsequent.
    • This is a desirable result, but the Notice does not make the reasoning behind it very clear.   Basically it says that because the Affordable Care Act did not expressly state that the employer’s taxable year governed, the Service may now interpret “taxable year” to refer to plan years, including fiscal years.
  •  The $2,500 dollar limit will be indexed for cost of living adjustments for plan years beginning after December 31, 2013.
  • Employers whose health FSAs currently follow a calendar plan year may not change to a fiscal year “primarily” in order to delay application of the $2,500 reimbursement limit.
  • The Notice reminds that plan year changes must be for a “valid business purpose” (e.g., as a result of a merger or acquisition transaction) and any switch meant to delay application of the reimbursement cap will be disregarded (the original calendar year format will remain in effect).
  • The $2,500 limit must be prorated over a short plan year that begins after 2012.  For instance, a plan year beginning April 1, 2013 and ending December 31, 2013 may allow reimbursement of only $1,875 ($2,500 x .75)
  • The $2,500 limit applies on an employee-by-employee basis.  Thus, an employee who covers a spouse and several dependents under a group health plan must fit reimbursements for the whole family within a single $2,500 budget.  Conversely, if each of two spouses may participate in a health FSA as employees, they each are entitled to a $2,500 budget even if they both participate in the same health FSA sponsored by the same employer.
  •  The $2,500 limit applies on a “controlled group” basis.  If an employee performs services for several corporations elated by ownership (e.g., parent – subsidiary) and participates in multiple health FSAs, the employee’s total health FSA budget under all cafeteria plans within the “controlled group” of corporations is limited to $2,500.  The same would be true if the related businesses were partnerships or LLCs under “common control,” and also under “affiliated service group” rules.
  •  Conversely, if an employee performs services for several employers that are not related by ownership at the requisite “controlled group” levels, the employee may enjoy a separate $2,500 budget under each employer’s health FSA.
  • With regard to employer contributions under a cafeteria plan, often called “flex credits,” the flex credits will count towards the $2,500 (and reduce the employee’s salary deferral limit) if the employee can elect to receive the flex credits as cash or as a taxable benefit.  Flex credits that are only usable in the health FSA for reimbursed medical expenses will not offset the $2,500 limit, however.
  • The $2,500 limit only applies to health FSA reimbursements and not to salary reduction contributions to any of the following:
    • Dependent care reimbursement accounts
    • “Premium only” or premium conversion portions of a cafeteria plan
    • Health Savings Accounts
    • Health Reimbursement Accounts (technically, treated as employer contributions).
  • Unused salary reduction contributions to a health FSAs that are carried over after the end of a plan year into a grace period (not to exceed 2 ½ months into the subsequent plan year) do not count against the $2,500 limit applicable for the subsequent plan year.
  • The Notice provides a self-correction procedure that an employer may use when, despite timely amendment of the plan to impose the $2,500 limit, one or more employees exceeds the limit.  The conditions for self-correction are as follows:
    • The terms of the plan apply uniformly to all participants (a requirement of proposed cafeteria plan regulations from 2007).
    • The excess reimbursements were the result of a reasonable mistake by the employer and not due to willful neglect.
    • Reimbursements that exceed the $2,500 limit are paid to the employee as wages and reported on Form W-2 for the calendar year that includes the end of the cafeteria plan year in which the correction takes place.
    • The employer’s federal tax return must not be under audit for cafeteria plan issues for any plan  year in which the dollar limit was exceeded.
    • Self-correction presumably will be on an “honor system,” for, as I noted in an earlier post, the IRS will not be able to track health FSA reimbursement amounts via Form W-2 reporting of health care costs.
  •  A retroactive cafeteria plan amendment to impose the $2,500 reimbursement limit may be adopted at any time before December 31, 2014, provided that the plan has been operated in compliance with the dollar limit during the interim period.   Illustrations in the Notice make clear that his relief is available even to employers with calendar year health FSAs; i.e. an amendment could be adopted on December 31, 2014 that takes effect January 1, 2013.

The Notice requests public comment on whether modifications to the “use-it-or-lose-it” rule are in order given the new dollar limit on annual reimbursements.  The use-it-or-lose-it rule was meant to prohibit (mis)use of a flex plan to defer compensation from one year to another but that goal largely is served by the cap on reimbursements.  Thus the Service seeks comments on “different form[s] of administrative relief” from the use-it-or-lose-it rule, instead of or in addition to the 2½ month grace period rule.

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Update on Fiscal Year Health FSAs and the $2,500 Limit

On January 10, 2011 I posted about how employers with health FSAs that follow a fiscal year might comply with the $2,500 deferral dollar limit going into effect on January 1, 2013. This post updates and corrects the earlier post as follows:
Notice 2012-9, which provides updated guidance on Form W-2 reporting of the value of group health care, exempts most health FSAs from the reporting requirement. The specific exemption applies to health FSAs that are exempt from HIPAA because they are funded entirely by employee salary deferrals, or because any employer contribution is $500 or less. (W-2 reporting of health care is waived entirely for employers filing fewer than 250 Forms in 2013, based on 2012 employment figures.)
• As a consequence, the IRS will not be able to monitor, through tax returns, any instances in which employee salary deferrals in 2013 exceed the $2,500 limit.
• One of the proposed approaches described in my January 10 post – namely, stopping deferrals at the $2,500 mark – would violate the requirement, set forth in the 2007 Proposed Regulations, that employee salary deferrals be taken in intervals that are uniform for all participants, which in turn potentially could disqualify the plan. (Proposed Treas. Reg. § 125-5(g)(2)). It is possible the IRS will address this method in future guidance but until such time it is not recommended.
• Another proposed method – “front-loading” the 2012-2013 deferral amount so that only $2,500 is deferred in the 2013 portion of the fiscal year – would not expressly violate Section 125 regulations because they do not require deferrals be made in uniform amounts, only uniform intervals. However this method could be viewed as inconsistent with the spirit, if not the letter, of the uniform coverage rule, which prohibits timing deferral payments based on the rate or amount of covered claims incurred. Front-loading is also arguably inconsistent with the uniform deferral rate requirement. An employer could also pro-rate the higher 2012 deferral amount and the lower 2013 deferral amount across the 12 month fiscal year but this would require that the employer reduce deferrals in the first half of the 2013-3014 fiscal year to equal $2,500, when combined with the pro-rated deferrals during the latter half of the 2012-2013 fiscal year. Clearly, timing of the fiscal year start (whether early in 2013, or late in the year) may make the front-loading or pro-rated options unaffordable for some participants.
• Even if unequal deferral amounts are permitted, the actual functioning of the pro-rated or front-loaded method could result in violation of Section 125’s nondiscrimination rules, specifically the rule that key employees receive no more than 25% of aggregate tax qualified benefits under a plan in any given year. This easily could occur if, for instance, shareholders and executives of a business typically were the only participants who deferred in excess of $2,500 per year, and continued to defer $5,000 per year under the pro-rated/front-loading method.
• The third method mentioned in my earlier post – imposing the $2,500 deferral cap at the start of the 2012-2013 fiscal year, is the most conservative approach to take but also the approach that will be most unpopular with participants who are accustomed to deferring significant amounts of money in prior plan years.
• At this point, any further guidance from the IRS would only be useful for employers whose fiscal years begin March 1 or later, as February 1 start date plans are almost through open enrollment. It may well be that the Service recognized that sponsors of fiscal year health FSAs would face administrative and legal obstacles to implementing the $2,500 limit and decided that the less the said about the matter, the better.

I want to thank my client and good friend Mike Igoe of Igoe Administrative Services in San Diego, California, for providing the ideas and impetus behind this post. There are very few true experts in this area, but Mike is one of them. Thanks, Mike.

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Health FSA Dollar Limit for 2013 Impacts Some Fiscal Year Plans Now

The Affordable Care Act limits salary deferrals that may be made under a health flexible spending account (FSA) to $2,500 in “taxable years” beginning on or after January 1, 2013. However Section 125 cafeteria plans that include health FSAs subject to the dollar limit, and that follow a fiscal rather than calendar plan year, need to take steps now to apply the dollar limit over their 2012 – 2013 plan year.

That is because, for purposes of the 2013 dollar limit, the term “taxable year” refers not to the plan year but to the taxable year of the employee participating in the health FSA. Almost universally, this will be the calendar year. The first fiscal plan year that will overlap with 2013 begins February 1, 2012 (ending January 31, 2013). Fiscal year plans that currently permit salary deferrals in excess of $2,500 must ensure that deferrals occurring over the 2013 calendar year do not exceed the $2,500 cap.

For instance, a plan that follows an April 1 – March 31 fiscal year and currently permits a maximum health FSA reimbursement of $6,000 would ordinarily allow participants to defer $500 per month under the plan. For the plan year beginning April 1, 2012 and ending March 31, 2013, this would permit salary deferrals of up to $1,500 to occur between January 1, 2013 and March 31, 2013. A participant deferring the maximum amount in the current plan year would be limited to deferring $1,000 over the balance of the 2013 calendar year (April through December), or only $111.11 per month.

We do not yet have any specific guidance from the IRS on applying the new dollar limit to a fiscal year plan, and the pro-rata method described above is only one option.

Other options might include (a) allowing the current rate of deferrals to continue into 2013, but cutting them off as soon as they reach the $2,500 dollar limit, and (b) imposing the $2,500 dollar limit as of the beginning of the 2012-2013 fiscal plan year. One trusted research source, EBIA’s Cafeteria Plans (©2011 Thompson-Reuters) mentions “front-loading” the deferrals during 2012, so that the “old” budget is met even while deferrals made during the 2013 year stay within the new dollar limit. Even were the IRS expressly to sanction the front-loading approach, it might not be financially workable for employees, particularly under fiscal year plans that begin late in the calendar year. Although guidance from the IRS is needed on this and a number of other transition compliance points, employers with early fiscal year starts do not have the luxury of waiting much longer.

Whichever transition method is chosen, employers promptly should communicate their choice to plan participants and work closely with their payroll departments, or their third party payroll providers, to ensure that they transition smoothly into the new dollar limit applicable January 1, 2013 and beyond.

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Filed under Affordable Care Act, Cafeteria Plans, Flex Plans, Health FSA, PPACA

Cashout Feature Would Replace “Use it or Lose It” Rule for Medical FSAs

U.S. Representatives Charles Boustany (R. Louisiana) and John Larson (D. Conn.) have proposed a bill, the Medical Flexible Spending Account Improvement Act (H.R. 1004), that would repeal the “use it or lose it rule” applicable to medical flexible spending accounts or “FSAs” effective January 1, 2013. A prior version of this bill was introduced in 2009, also with bipartisan support, but appears to have died in committee.

The use it or lose it rule is the most often-cited reason that employees choose not to enroll in medical FSAs, which often form part of a cafeteria or “flex” plan under Section 125 of the Internal Revenue Code. The rule exists because Section 125 plans are barred from operating as a means of deferring income from one year to the next. Employees who overestimate their reimbursable expenses must leave unused, deferred cash compensation in their employers flex accounts unless they can come up with last-minute reimbursable expenses, such as new eyeglasses.

The Act would allow employees to take their unused health FSA balance as a taxable distribution after the close of the plan year to which the balance relates, and no later than the end of the 7th month following the plan year end. Thus, an employee who participates in a medical FSA with a calendar plan year would be able to receive distribution of their unused 2013 account balance on or after January 1, 2014, but no later than July 31, 2014. The distributed amount would be included in the employee’s taxable income for 2014.

The bill contains a transition rule applicable for plan years that begin before the date the bill is enacted, allowing individuals to make a new medical FSA election or revise an existing one so long as the new election is made within 90 days after the date of enactment of the bill.

Medical FSAs are subject to other changes under PPACA; this year the ability to receive reimbursement of over-the-counter medicines ended, unless a doctor’s note for the OTC item is provided. And in 2013 the maximum reimbursement amount – currently without a ceiling – is capped at $2,500.

Eliminating forfeitures under health FSAs will expose employers to more out of pocket expenses in operating these arrangements. Employers must act as insurers under these plans, making 100% of the reimbursement budget available to each employee on day 1 of the plan year, and can get burned by employees who cash out and quit early in the calendar year. Forfeiture accounts will no longer be available to make up for such losses. However employers’ exposure also will be capped by the $2,500 dollar limit, and if elimination of the use it or lose it rule increases medical FSA participation, they will enjoy a reduced employment tax burden.

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