The Internal Revenue Service recently issued Notice 2013-71 (“the Notice”) which modifies the “use-or-lose” rule for health flexible spending accounts (“FSAs”) established pursuant to Section 125 of the Internal Revenue Code (“the Code”).  The “use-or-lose” rule provides that any monies remaining in an FSA at the end of a plan year are forfeited and cannot be used to reimburse employees for medical expenses incurred during the following year.  In 2005, the IRS modified the “use-or-lose” rule by adopting the grace period rule, which provides that a Section 125 cafeteria plan may allow an employee to use the balance remaining from the previous year to pay expenses incurred for some qualified benefits during the first two and a half months of the following year.

Pursuant to the Notice, the “use-or-lose” rule has been further modified to permit employers to modify their Section 125 plans to allow an employee to carry over up to $500 in unused funds to the next plan year.  The carried-over monies may be used to reimburse the employee for qualified medical expenses incurred at any point during the following plan year.  A plan that incorporates the carryover provision cannot also use the grace period rule. 

Using the carryover option does not affect the ability of a health FSA to provide for the payment of expenses incurred in one plan year during a permitted run-out period at the beginning of the following plan year.  Therefore, for plans using the carryover option, an employee’s unused health FSA balance at the end of the prior year may be carried over and used for:  (a) expenses incurred in the prior plan year, if claimed during the plan’s applicable run-out period that begins at the end of the prior plan year; or (b) expenses incurred at any time during the current plan year.

Additionally, a Section 125 plan is permitted to use a “first in, first out” approach by treating reimbursements of all claims for expenses that are incurred in the current plan year as reimbursed first from unused amounts credited for the current plan year, and only after exhausting these amounts, as reimbursed from unused amounts carried over from the preceding year.

An employer wishing to utilize the new carryover option must amend its plan on or before the last day of the plan year immediately preceding the year in which the option will be implemented.  Additionally, any plan that began in 2013 can be amended to adopt the carryover provision at any time before the end of the 2014 plan year.  If the employer chooses to amend its plan to incorporate the carryover option, it must eliminate the grace period provision (if already included in the plan) by no later than the end of the plan year from which amounts may be carried over.

An employer wishing to adopt or modify its Section 125 plan may have to first negotiate with its unions.  We recommend that employers seek legal advice prior to implementing a new plan or changing an existing one.  Please contact us if you have any questions about the Notice or would like assistance reviewing and/or modifying your FSA.

THIS MEMORANDUM IS MEANT TO ASSIST IN GENERAL UNDERSTANDING OF THE CURRENT LAW.  IT IS NOT TO BE REGARDED AS LEGAL ADVICE.  THOSE WITH PARTICULAR QUESTIONS SHOULD SEEK THE ADVICE OF COUNSEL.

© Lamb & Barnosky, LLP 2013

1. An employer may provide for and set a specified period (“the run-out period”) immediately following the end of a plan year during which an employee can still submit a claim for reimbursement of expenses