United States: Use It Or Lose It: New IRS Guidance Permits Carryover For Health FSAs

Last Updated: November 26 2013
Article by Heather Abrigo and Dawn Sellstrom

The IRS has relaxed the rule that any amounts remaining at the end of a plan year in a health flexible spending account (health FSA) must be forfeited. But whether cafeteria plans should be amended to include this new provision is a question plan sponsors should consider carefully.

Under IRS Notice 2013-71 (Notice), issued on October 31, 2013, a cafeteria plan may permit up to $500 in an employee's health FSA remaining unused at the end of a plan year to be carried over and used to reimburse medical expenses incurred in the entire following year. This is a change to the long-standing "use-or-lose" rule that restricted employees from carrying over amounts to a subsequent year. The change comes as a result of comments the IRS received after the release of Notice 2012-40, which provides guidance on the $2,500 maximum limit on the amount of salary deferrals an employee may contribute to a health FSA. In this Alert, we provide background on the old rule, explain how it is modified by the Notice and discuss some of the outstanding issues that plan sponsors will need to address in deciding whether to implement the new carryover feature.

Adding the carryover feature will require (1) an amendment to the plan, (2) elimination of the grace period feature if the cafeteria plan has one, and (3) notice to participants about the changes as soon as possible if they are being implemented for 2014. In addition, there are considerations related to COBRA, HIPAA and HSAs that need to be understood. All of these are covered in more detail below.


A cafeteria plan that includes a health FSA may allow participants to make pre-tax salary deferral contributions to the health FSA up to $2,500 (for 2013, and indexed for inflation for plan years beginning after December 31, 2013; however, the $2,500 limit is unchanged for 2014). To help participants who may have a balance in their health FSA at the end of a plan year, cafeteria plans may also provide for a "run-out period" and/or "grace period." To the extent that participants do not exhaust their health FSA balance at the end of the run-out period and/or grace period, under the current rules, any amount remaining is forfeited.

A run-out period is a period after the end of the plan year during which a participant may submit claims for expenses for eligible medical expenses incurred during that prior plan year. So, for example, if a participant deferred $2,000 in 2013, incurred $2,000 of covered medical expenses in 2013, but sought reimbursement for only $1,700 of those expenses prior to the end of the plan year, he would be able to submit reimbursement claims for the remaining $300 during the run-out period in 2014. However, unless the FSA also has a grace period, he could not submit claims for new expenses incurred in 2014 during the run-out period.

A grace period extends the period during which a participant may incur eligible expenses for up to 2-1/2 months after the close of a plan year. A run-out period may follow a grace period, but IRS rules limit a permitted grace period to no longer than 2-1/2 months after the end of a plan year.

It is important to note that the cafeteria plan document must provide for the run-out and/or grace periods.

The new $500 carryover rule

The Notice permits plan sponsors to implement a carryover feature under which up to $500 in a health FSA that remains at the end of the plan year will be carried over into the following year. However, in order to implement the new carryover rule, plan sponsors should be aware of the following:

  • Purpose.The carryover amount may be used to pay or reimburse medical expenses incurred during the entire plan year to which it is carried over (e.g., the participant may use the $500 carryover from 2013 for eligible expenses incurred at any time in 2014). 
  • Salary Deferral Limit.The $500 carryover does not count toward the $2,500 annual limit on salary deferrals. A participant may carryover $500 from his or her unused health FSA balance from 2013 into 2014, and may also elect to contribute the full $2,500 limit for 2014. 
  • No Grace Period Permitted.A cafeteria plan may not have a grace period in the year into which an amount is carried over under the $500 carryover feature, but may have a grace period for the prior year. For example, a plan may provide for a carryover of $500 from the 2013 plan year to the 2014 plan year. It is acceptable if the FSA had a grace period at the beginning of 2013 (for amounts not used under the 2012 FSA), but it must eliminate the grace period in 2014 (related to 2013 account balances). A health FSA may continue to feature a run-out period, even if a carryover feature is added. 
  • Amendments.Plan sponsors must amend their cafeteria plans by the last day of the plan year from which the carryover is permitted, and the amendment should be retroactive to the first day of that plan year. There is an exception for the 2013 plan year. Plan sponsors that want to amend their health FSA for the plan year beginning in 2013 to allow for the carryover into 2014 must amend their plans no later than the last day of the plan year that begins in 2014 (or December 31, 2014 in the case of a calendar year plan). For non-calendar year plans, the deadline to adopt the amendment to add a carryover feature may go well beyond 2014. For example, if a cafeteria plan has a plan year ending June 30, the plan year that begins in 2013 begins on July 1, 2013 and ends June 30, 2014. That health FSA must be amended by June 30, 2015 to allow for the carryover (the last day of the plan year that begins in 2014).

Special timing rules apply if a health FSA must also eliminate a grace period. To the extent that a plan sponsor wants to add a carryover feature in a health FSA that already has a grace period in place, the plan must also be amended to eliminate the grace period for that year. An amendment to eliminate a grace period must be adopted by no later than the end of the plan year from which amounts may be carried over. Thus, to implement a carryover feature for 2013 accounts, a health FSA with a calendar year plan year would have to be amended by the end of 2013 (i.e., the plan year from which amounts may be carried over) to eliminate the upcoming grace period. 

  • Notice Required.If plan sponsors want to adopt the carryover feature, they will have to notify participants about the new feature. It may be necessary to provide the notice to participants in advance of the deadline to adopt a plan amendment. For example, if plan sponsors want to amend their plans in 2013, they have until the end of 2014 to adopt the amendment (for calendar year-end plans, and as long as a grace period is not also being eliminated). However, participants should be notified as soon as possible about the carryover feature since it will impact their 2013 balances, and the amount available for reimbursements in 2014.

    Employers that adopt the carryover for 2013 balances, and currently have a grace period in place, will want to communicate the change clearly and expeditiously. This is because participants may be planning on using more than $500 of their 2013 health FSA balance for expenses they are planning to incur during the 2014 grace period, which will have to be eliminated.

Issues to Consider

As plan sponsors contemplate this new rule and how it impacts their benefit plans, there are several issues to consider:

  • Impact on HSA participation. Employees that are covered by "general purpose" health FSAs, which generally permit the reimbursement of any eligible medical expense, are not eligible to make contributions to an HSA because the FSA coverage is considered disqualifying, non-high deductible health plan (HDHP) coverage. The Notice does not address how the $500 carryover impacts an employee who elects to be covered under a HDHP for the plan year into which an amount is carried over, and thus also wants to make contributions to an HSA for that year. Based on the available guidance concerning HSAs and health FSA grace periods, such a carryover may cause the employee to be ineligible for an HSA.

    Although the IRS has not yet addressed these issues related to the new carryover feature, available guidance related to grace periods and their impact on HSAs may provide plan sponsors with some potential solutions. For example, plan sponsors may want to consider adding an opt-out provision related to the carryover for such employees wanting to make contributions to an HSA. Alternatively, plan sponsors may want to consider converting the carryover amount to a limited purpose HSA-compatible FSA that may include: (i) a limited-purpose health FSA (i.e., a health FSA that reimburses only dental, vision, and/or preventive care expenses); (ii) a post-deductible health FSA (i.e., a health FSA that reimburses medical expenses only if incurred after the Code §223(c)(2)(A)(i) minimum annual deductible has been satisfied); or (iii) a combination limited-purpose and post-deductible health FSA. Again, these options have not yet been addressed by the IRS specifically related to the carryover feature so we strongly urge plan sponsors to consult with their benefits counsel before proceeding. 
  • Impact on COBRA obligations. Another issue is how the new carryover rule affects COBRA. Generally, health FSAs are considered group health plans and are subject to COBRA obligations. Any unused amounts remaining in an employee's health FSA as of termination of employment and eligibility under the health FSA may be forfeited, unless the employee elects COBRA coverage, subject to certain exceptions. One such exception limits COBRA coverage available under a FSA that is an "excepted benefit" (i.e., the health FSA limits the maximum amount that may be reimbursed and other major medical coverage is available -- see our further discussion below). COBRA is required only if the participant has an underspent health FSA. In that situation, he or she must be offered COBRA through the end of the plan year of the qualifying event.

    The Notice provides only that any unused amounts remaining in an employee's health FSA at termination of employment is forfeited unless that employee elects to continue participation in the health FSA by electing COBRA. The Notice does not address how to handle an employee's (or other qualified beneficiary's) COBRA election under a health FSA that includes a carryover provision. While it appears, based on the IRS' statement in the Notice, that qualified beneficiaries under COBRA may benefit from the carryover, at least to some extent, it is not clear how qualified beneficiaries should benefit under COBRA from a carryover, or for how long. IRS guidance on this issue is needed. 
  • Excepted Benefits Under HIPAA. A health FSA will qualify as an "excepted benefit" under HIPAA and the Patient Protection and Affordable Care Act of 2010 (PPACA) if the maximum amount that may be reimbursed under the health FSA is limited to the greater of (i) two times the participant's salary reduction, or (ii) the participant's salary reduction plus $500. The employer must also make other major medical coverage available to participants. For example, a health FSA is an excepted benefit if the plan sponsor does not make any contribution to the health FSA or does not contribute more than $500 to the health FSA and other major medical coverage is available. However, it is not clear how adding a carryover feature will impact certain FSAs (e.g., one with employer contributions), and if it could cause the health FSA to fail to meet the exception.

    Many typical health FSAs accept only employee salary deferral contributions and will be excepted benefits, even if the carryover feature is implemented. If a health FSA does not qualify as an excepted benefit, however, the health FSA is subject to HIPAA's special enrollment and other portability rules. A health FSA that does not qualify as an excepted benefit is also subject to many of PPACA's mandates.

What now?

To determine whether to amend health FSAs to allow for the $500 carryover, plan sponsors should consider:

  • Whether the plan should be amended for 2013 or for 2014 to provide for the carryover. If a plan sponsor decides to implement the carryover for 2013, it should immediately determine how to communicate the change to employees, and make sure that the plan is amended to eliminate the grace period for 2014, if any. Plan sponsors need to be cognizant of how such a change will affect their employees that will have more than $500 in their health FSA and expect to utilize that balance in the grace period; 
  • The impact this might have on individuals who are currently contributing to a health FSA but may elect coverage under a HDHP and wish to start participating in a HSA; and 
  • How this rule impacts terminated employees and the plan's COBRA obligations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Heather Abrigo
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