The IRS issued a notice on October 31 modifying the long-standing “use-or-lose” rule that applies to health flexible spending arrangements (“Health FSAs”).  The new rule permits participants to apply up to $500 of unused Health FSA contributions to pay for expenses incurred in the next plan year, if the employer amends its Health FSA to permit such carryovers.  Although plan sponsors are not required to offer the carryover, for the first time in 30 years, they have the option to do so.

Participants in Health FSAs may contribute up to $2,500 per year (indexed) to a Health FSA on a pre-tax basis to pay for medical expenses not otherwise covered by an employer’s health plan.  Health FSAs come at a price, however — generally, unused amounts contributed to a Health FSAs must be forfeited at the end of the year and cannot be carried over to a future year or cashed out.  The IRS modified this rule in 2005, permitting plans to adopt a “grace period” that allows a participant to use contributions made in one year to pay for medical expenses incurred during the first 2 ½ months of the next year.

In response to public comments, and in particular the concern that the forfeiture requirement was discouraging lower paid employees from making Health FSA contributions, the IRS has now added another option for employers — they may amend their Health FSA plans to permit employees to carry over $500 in contributions from year 1 to pay year 2 medical expenses.  Employers are not required to permit carryovers, and may specify a carryover amount of less than $500.

There are several limitations and requirements:

• A plan may not provide both a carryover allowance for a year and a simultaneous grace period for the same year.
• If a plan permits carryovers, the same carryover limit must apply to all plan participants.
• The amount available to reimburse Health FSA expenses in any given year may not exceed the limit imposed by the Patient Protection and Affordable Care Act ($2,500, indexed) plus the $500 carry-over amount.
• Carried over amounts may be used only for eligible expenses; they may not be converted to any other type of benefit, and they may not be exchanged for cash.
• Participants may not accumulate more than $500 of carryover funds; any unused amounts in excess of the maximum allowance must be forfeited.
• Employers who wish to take advantage of the new rule must amend their plans by the end of the plan year in which the contribution is made, but employers who wish to permit carryovers from plan years beginning in 2013 have until the end of the 2014 plan year to adopt the necessary amendments.  Although employers can adopt the carryover for plan years beginning in 2013, employers that currently offer a grace period might not, as a practical matter, wish to eliminate the grace period and offer the carryover earlier than for plan years beginning in 2014.

In addition, carryover amounts could impede an employee’s ability to participate in a Health Savings Account (“HSA”) for the year following the year in which the contribution is made (i.e., for year 2, if an amount is carried over from year 1 to year 2).  Although the notice does not address this issue, we understand from discussions with government officials that it might be possible to design the FSA carryover to be compatible with HSAs.  Employers with High Deductible Health Plans should keep this in mind when amending their Health FSAs to allow carryovers.