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Health flexible
spending
arrangements
(health FSAs)
are popular
savings vehicles
for medical
expenses, but
their use has
been held back
by a strict
use-or-lose
rule. The IRS
recently
announced a
significant
change to
encourage more
employers to
offer health
FSAs and boost
enrollment. At
the plan
sponsor's
option,
employees
participating in
health FSAs will
be able to carry
over, instead of
forfeiting, up
to $500 of
unused funds
remaining at
year-end.
Health expenses
Health FSAs are
designed to
reimburse
participants for
certain health
care
expenditures,
typically
expenses that
qualify for the
medical and
dental expense
deduction.
Medical
supplies, such
as eye glasses
and bandages,
are usually
treated as
qualified
expenses.
However,
nonprescription
medicines (other
than insulin)
are not
considered
qualified
medical
expenses.
Health FSAs are
often funded
through
voluntary salary
reduction
agreements with
the
participant's
employer under a
cafeteria plan.
In that case,
they are very
taxpayer-friendly
because no
federal
employment or
federal income
taxes are
deducted from
the employee's
contribution.
The employer may
also contribute
to a health FSA.
However, there
are special
rules which
govern employer
contributions.
Typically,
participants
designate at the
beginning of the
year the amount
they want to
contribute to
their health FSA
and these
amounts are
deducted from
their pay. For
2014, an
employee's
salary reduction
contributions
cannot exceed
$2,500. The
$2,500 cap is
very important
because
cafeteria plans
that do not
limit health FSA
contributions to
$2,500 are not
treated as
cafeteria plans,
and all benefits
offered under
the plan are
included in the
participants'
gross income.
Use-or-lose rule
As mentioned,
the use-or-lose
rule is a
drawback to
health FSAs.
Unused amounts
remaining in the
health FSA at
year-end are
forfeited.
Employers are
not allowed to
refund any
unused funds in
a health FSA.
Critics of the
use-or-lose rule
argue that it
has discouraged
participation in
health FSAs
because many
employees do not
want to risk
forfeiting
unused funds.
Often,
participants
have to scramble
at year-end to
use their health
FSA dollars
Grace period
option
A few years ago,
the IRS modified
the use-or-lose
rule. The IRS
allowed
cafeteria plans
to adopt a grace
period.
Participants can
use amounts
remaining in a
health FSA at
year-end for up
to an additional
two months and
15 days. This
grace period is
optional.
Employers are
not required to
offer the grace
period, although
many do.
Carryover option
At its option,
an employer may
now amend its
cafeteria plan
to provide for
the carryover to
the immediately
following year
of up to $500 of
any amount
remaining unused
as of the end of
the year in a
health FSA. The
carryover of up
to $500 may be
used to pay or
reimburse
qualified
expenses under
the health FSA
incurred during
the entire plan
year to which it
is carried over.
Additionally,
the carryover
does not count
against or
otherwise affect
the salary
reduction limit
($2,500 for
2014) for health
FSAs. However,
the new rules do
not allow
participants to
cash out unused
health FSA
amounts or
convert them to
other types of
benefits.
The maximum
carryover amount
is $500. An
employer can
choose to offer
a $0 carryover,
a $500 carryover
or any amount in
between. As we
discussed, the
carryover is
optional.
Employers can
choose not to
offer any
carryover.
Employers cannot
offer both the
grace period and
the carryover.
It is a choice
of either the
grace period or
the
carryover....or
neither. The
employer and not
the participant
decides. In
regulations, the
IRS described
how employers
can amend their
cafeteria plans
to provide for
the carryover
and how they
can, if they
choose, replace
the grace period
with the
carryover.
Let's take a
look at an
example: Jacob
participates in
a health FSA
under his
employer's
cafeteria plan.
At year-end,
Jacob has $255
remaining in his
health FSA.
Jacob's employer
never offered a
grace period but
opted to allow
participants to
carry over up to
$300 of unused
health FSA
dollars. Jacob
can carry over
all of his $255
in unused health
FSA dollars.
If you have any
questions about
the new
carryover option
or health FSAs,
please contact
our office.
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