United States: IRS Provides a 2 ½ Month Grace Period After end of Plan Year to Incur Reimbursable Expenses Under Flexible Spending Arrangements

For example, for cafeteria plans that use a calendar year, participants’ reimbursable FSA expenses for the plan year will no longer be limited to expenses incurred through December 31 of the plan year, but may now include expenses incurred through March 15 of the year following the applicable plan year.

FSAs are benefit arrangements provided under cafeteria plans that satisfy the requirements of Section 125 of the Internal Revenue Code. Cafeteria plans allow employees to pay for qualified benefits with pre-tax money, and FSAs provide a mechanism for doing so, typically with regard to specified health care and dependent care expenses. An FSA allows a participant to contribute a set amount of pre-tax money that is then available to reimburse the participant for such expenses that are incurred during a given plan year.

A cafeteria plan is prohibited from deferring participants’ compensation by, for example, allowing participants to apply their contributions for a given plan year to benefit expenses incurred during a later plan year. This is known as the "use-it-or-lose-it" rule, as contributions which are not used during the plan year are forfeited.

Notice 2005-42 permits plan sponsors to implement a 2 ½ month grace period (not extending beyond the 15th day of the third month following the immediately preceding plan year to which it relates). During this grace period, participants can incur expenses and be reimbursed from their contributions made in the immediately preceding plan year. Thus, participants effectively can be given a total of 14 ½ months (the 12 months in the plan year plus the grace period) to use their contributions for a plan year before the amount is forfeited under the "use-it-or-lose-it" rule.

During the grace period, unused contributions can only be applied to the type of benefit for which they were initially contributed. For example, unused amounts in a health care FSA may not be used to reimburse expenses under a dependent care FSA, and vice versa.

The grace period overlaps with the new plan year, so benefit expenses incurred during that period may be paid from either the unused contributions from the previous plan year, if any, or the contributions made during the new plan year.

As under current practice, employers may continue to provide a "run-out" period after the end of the grace period, during which claims for reimbursement of qualified benefit expenses incurred during the grace period and the previous plan year may be submitted.

Effective immediately, an employer is permitted to adopt the grace period provided in Notice 2005-42 for the current plan year (and subsequent cafeteria plan years) by amending the plan document before the end of the plan year. For example, employers using a calendar plan year who amend their plan documents before the end of 2005 will be able to provide participating employees a grace period ending March 15, 2006 for the 2005 plan year. Plan sponsors intending to implement a grace period for 2005 should notify their plan recordkeepers as soon as possible to allow for any necessary changes in the recordkeeping system.

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.