Notice 2013-71

Fact Sheet

News Release

The IRS has changed the use-or-lose rule for cafeteria plans to allow health FSAs to offer carryovers of up to $500 at the end of a plan year, to be used for qualified medical expenses incurred in a following plan year. The carryover is an alternative to offering a grace period—health FSAs allowing carryovers from a plan year cannot also have a grace period with respect to that year. The carryover guidance also clarifies the scope of previously announced transition relief allowing non-calendar-year plans to be amended to permit certain election changes during the 2013 plan year. Here are highlights.

• Carryovers Permitted. Up to $500 of an employee’s unused health FSA balance may be carried over—plans can also set lower carryover amounts or have none at all. Unused amounts in excess of $500 (or a lower amount specified in the plan) are forfeited. Carryovers cannot be cashed out or converted to any other taxable or nontaxable benefit and will not affect a participant’s annual health FSA salary reduction limit (currently $2,500, unless the plan has a lower limit). Unused carryovers remaining at termination of employment are forfeited unless the employee elects COBRA under the health FSA. [Comment: Although the guidance references termination of employment, we wonder whether it is loss of health FSA eligibility that should trigger the forfeiture (for example, some plans allow participation to continue until the end of the month in which termination occurs). Other COBRA issues include whether carryovers should impact calculation of the COBRA premium.]
• Ordering Rule. During the run-out period, potential carryover amounts may be used either for prior-year or current-year claims. When both current-year contributions and carryovers are available to pay a claim, plans may use current-year contributions first. Examples in the guidance illustrate this ordering rule. [Comment: While the ordering rule used in the example is permissive, it may be a best practice. Using current-year contributions first leaves the carryover available to reimburse prior-year expenses submitted during the run-out period.]
• Plan Amendments. Offering carryovers will require a plan amendment. The amendment generally must be adopted on or before the last day of the plan year from which amounts are carried over and can be effective retroactively to the first day of that plan year, provided the plan operates in accordance with IRS guidance and participants are informed of the carryover provision. Under a special rule, employers adding a carryover provision for the 2013 plan year (i.e., to permit 2013-to-2014 carryovers) have until the last day of the 2014 plan year to adopt an amendment.
• No Grace Period. To offer carryovers, a health FSA with a grace period must be amended to eliminate the grace period before the end of the plan year from which amounts would be carried over. The guidance notes that the ability to eliminate a grace period for the year in which the amendment is adopted may be subject to non-Code legal constraints. [Comment: Employees who expected to have more than $500 available during a grace period to pay subsequent-year claims might object to its elimination. Sponsors considering this action may wish to consult with counsel regarding whether ERISA or state laws might restrict their ability to remove a grace period during the year to which it applies.]
• HSA Eligibility. HSA eligibility was not the focus of the carryover guidance, but addition of a carryover feature raises issues in this regard. [Comment: When a general-purpose health FSA has a grace period, employees remain HSA-ineligible until the first day of the first month following the end of the grace period unless they have a zero balance on the last day of the plan year. Carryovers to a general-purpose health FSA would seem to result in HSA-ineligibility for the entire subsequent plan year, even after the carryover is exhausted. But there may be plan designs that could ameliorate this result (e.g., allowing carryovers to be made to a limited-purpose health FSA)—further guidance would be welcome.]
• Election Change Transition Relief. Transition relief announced in the preamble to the proposed employer shared responsibility (play or pay) regulations allows non-calendar-year plans to be amended for the 2013 plan year to permit employees to revoke or change their salary reductions for health coverage once or to prospectively elect salary reductions for such coverage without a change in status. The guidance clarifies that—(1) this transition relief is not limited to “applicable large employers” (i.e., those subject to the employer shared responsibility rules); and (2) amendments may be more restrictive than what the relief permits (for example, by allowing election changes only during a one-month period).

Comment: Many in the benefits community have worked hard for this change and it is great news, even though the timing of its announcement makes implementation more challenging. Employers wanting to allow 2013-to-2014 carryovers must act quickly to communicate the change to employees and put systems in place. And even those delaying implementation until next year will want to inform participants before their 2014 open enrollment window closes. Employers with grace periods will need to proceed more cautiously and decide whether terminating the grace period to allow for carryovers is a viable option. In all cases, employers should step back and review their options to decide on the best fit for their plans.