With the advent of health savings accounts and other types of consumer-directed health plans, there has been increasing pressure on the Internal Revenue Service (IRS) to eliminate its twenty-year-old “use it or lose it" rule applicable to health and dependent care flexible spending accounts (FSAs) under cafeteria plans. Treasury Secretary John Snow has said in the past that the rule could only be changed by Congress. However, he also suggested that the IRS and the Treasury Department may be able to "tinker" with the rule. The IRS has done just that with the issuance of IRS Notice 2005-42.
IRS Notice 2005-42
The IRS guidance permits cafeteria plans to reimburse participants for claims incurred during a two-and-a-half month grace period following the end of the cafeteria plan year. This development will likely encourage more prudent use of FSA funds in order to avoid the mad rush to incur expenses at the end of the year to avoid forfeitures. In order to take advantage of the grace period, cafeteria plan sponsors must amend their cafeteria plan documents before the end of the plan year to which the grace period applies. For example, if a plan sponsor wants to provide a grace period for the 2005 plan year, it must amend its calendar year cafeteria plan prior to the end of 2005 to provide participants with the right to be reimbursed from 2005 FSA contributions for eligible expenses incurred through March 15, 2006.
Requirements of the Grace Period
The grace period must:
Be offered to all participants in the cafeteria plan
Be applied immediately after the end of the plan year
Be applied towards qualified expenses incurred during the immediately preceding plan year or the grace period for contributions which remain unused at the end of the immediately preceding plan year
Be concluded by the fifteenth day of the third calendar month after the end of the immediately preceding plan year (i.e., for a calendar year plan, the grace period cannot extend beyond March 15)
In addition, those participants who do not use the remaining contributions or benefits before the end of the grace period must forfeit the funds at the end of the grace period (as was the case under the old “use it or lose it rules”)
Although the IRS guidance permits cafeteria plan sponsors to implement a grace period, it does not permit contributions to be cashed-out or converted to other taxable or nontaxable benefits. For example, if a participant retains a balance in a health FSA of $100 at the end of the grace period, that amount may not be allocated to pay eligible expenses under a dependent care FSA.
While the guidance is welcome relief for plan participants, there may be administrative concerns for an employer and its vendors in tracking claims and performing nondiscrimination testing. It will also likely complicate an employee’s ability to forecast expenses so as to avoid forfeitures beyond the grace period. Employers considering adopting the grace period may also need to consider adopting a longer claims filing period.