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Cafeteria Plans May Be Amended To Provide Participants More Time To Use Their FSA Benefits

By Bruce H. Schwartz
  • May 26, 2005

On May 18, 2005, the Treasury Department issued Notice 2005-42, which allows employers to modify their cafeteria plans to extend the deadline for reimbursement of health and dependent care expenses up to 2½ months after the end of the plan year.  Although this Notice will chiefly impact health Flexible Spending Arrangements (FSAs), it also applies to other cafeteria plan benefits, including dependent care assistance programs.  See http://www.irs.gov/pub/irs-drop/n-05-42.pdf for a copy of the Notice.

Background

A health FSA may be included as part of a cafeteria plan (also known as a section 125 plan).  FSAs allow employees to elect to have a portion of their earnings withheld on a pre-tax basis to be later drawn on as reimbursement or payment for qualified medical expenses. 

One of the biggest drawbacks for employees had been that any contributions for a plan year that were not used for expenses incurred during that year were forfeited (this is known as the "use-it-or-lose-it rule").  The new rule does not abolish the use-it-or-lose-it rule, but as Treasury Secretary John Snow stated, "The new rule will give workers with FSAs more time to pay for medical and dependent care expenses and will ease the year-end spending rush prompted by the prior rule."

Key Provisions of Notice 2005-42

The key provisions of Notice 2005-42 are:

  • 2½ Month Grace Period:  An employer has the option to amend its cafeteria plan to provide participants a grace period lasting no longer than 2½ months following the end of a plan year.  An employee may apply any unused FSA funds from the plan year preceding the grace period toward qualified expenses incurred during the grace period. 
  • Applicable To All Participants:  If adopted, the grace period must apply to all participants in the cafeteria plan.  The IRS has yet to clarify whether this would preclude employers from applying the grace period to certain benefits (such as a health FSA), but not others (such as dependent care). 
  • No Cash-Out, Conversion, or Carryforward:  During the grace period, unused FSA funds may not be cashed-out or converted to any other benefit.  This means that unused health FSA funds may not be used to pay or reimburse dependent care or other expenses incurred during the grace period.  Furthermore, the unused FSA funds at the end of the grace period are forfeited under the use-it-or-lose-it rule.  
  • Run-Out Periods Still Permitted:  Employers may provide a "run-out" period following the grace period to permit employees to submit their expenses incurred during the plan year and grace period. 
  • Amendment For The Current Plan Year Permitted:  An employer may adopt a grace period effective beginning with the current cafeteria plan year, provided that the plan document is amended before the end of the current plan year.
  • Future Guidance:  The IRS will modify Prop. Reg. § 1.125-1, Q&A 7 and Prop. Reg. § 1.125-2 , Q&A 5 to reflect Notice 2005-42.

Examples of How the Notice May Affect Cafeteria Plans

In Example One, an employer with a cafeteria plan year ending on December 31, 2005, amended the plan document before the end of the plan year to permit a grace period, which allows all participants to appl y unused benefits or contributions remaining at the end of the plan year to qualified benefits incurred during the grace period immediately following that plan year.  The grace period adopted by the employer ends on the fifteenth day of the third calendar month after the end of the plan year (March 15, 2006 for the plan year ending December 31, 2005). 

Employee X timely elected salary reduction of $1,000 for a health FSA for the plan year ending December 31, 2005.  As of December 31, 2005, X has $200 remaining unused in his health FSA.  X timely elected salary reduction for a health FSA of $1,500 for the plan year ending December 31, 2006.  During the grace period from January 1 through March 15, 2006, X incurs $300 of unreimbursed medical expenses.  The unused $200 from the plan year ending December 31, 2005 is applied to pay or reimburse $200 of X's $300 of medical expenses incurred during the grace period.  Therefore, as of March 16, 2006, X has no unused benefits or contributions remaining for the plan year ending December 31, 2005.  The remaining $100 of medical expenses incurred between January 1 and March 15, 2006 is paid or reimbursed from X's health FSA for the plan year ending December 31, 2006.  As of March 16, 2006, X has $1,400 remaining in the health FSA for the plan year ending December 31, 2006.

In Example Two, assume the same facts as Example One, except that X incurs $150 of medical expenses during the grace period (January 1 through March 15, 2006).  As of March 16, 2006, X has $50 of unused benefits or contributions remaining for the plan year ending December 31, 2005.  The unused $50 cannot be cashed-out, converted to any other taxable or nontaxable benefit, or used in any other plan year (including the plan year ending December 31, 2006).  The unused $50 is subject to the "use-it-or-lose-it" rule and is "forfeited."  As of March 16, 2006, X has the entire $1,500 elected in the health FSA for the plan year ending December 31, 2006.

Action Item for Employers

Employers that amend their cafeteria plans to provide a grace period will have to adjust their administrative and recordkeeping procedures accordingly.  It is hoped that the Internal Revenue Service will provide further guidance on whether adopting a grace period could impact the COBRA or HIPAA obligations of a Flexible Spending Arrangement.

©2005 Jackson Lewis P.C. This material is provided for informational purposes only. It is not intended to constitute legal advice nor does it create a client-lawyer relationship between Jackson Lewis and any recipient. Recipients should consult with counsel before taking any actions based on the information contained within this material. This material may be considered attorney advertising in some jurisdictions. Prior results do not guarantee a similar outcome.

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