What is the “use it or lose it” principle for flexible spending accounts?
The IRS requires flexible benefit plans to contain an element of risk, in order to receive preferred tax treatment. Thus, amounts selected for a flexible spending account (FSA) that are not used by the end of the plan year (or grace period, if applicable), must be forfeited by the employee. This is known as the use it or lose it
principle.
Employee Connie Barton opts to fund a health benefit account by allocating $500 of her salary to the account at the beginning of a calendar year. During the year, Connie's out-of-pocket expenses for health care are reimbursed to her. The reimbursements are treated as employer-provided health benefits
(for purposes of Internal Revenue Code Sec. 105), which make the benefits tax-free income to Connie. As a result, Connie's taxable income is reduced by the amount of the reimbursement. If Connie does not incur $500 in reimbursable expenses, she loses the money.
Optional grace period
Beginning in 2005, an employer may, at its option, amend its plan to provide for a grace period immediately following the end of each plan year. The grace period must apply to all participants in the plan and it may not extend beyond the 15th day of the third calendar month after the end of the immediately preceding plan year to which it relates (the 2 and month rule
).
More time to spend FSA funds. If a grace period is adopted, expenses for qualified benefits incurred during the grace period may be paid or reimbursed from benefits or contributions remaining unused at the end of the immediately preceding plan year. In other words, participants can be reimbursed for expenses incurred during the grace period as if they had been incurred in the immediately preceding year. The effect of the grace period is that a participant may have as long as 14 months and 15 days (12 months in the current plan year plus 2
months in the grace period) to use benefits or contributions for a plan year before those amounts are forfeited under the use-it-or-lose-it
rule.
An employer with a cafeteria plan year ending on December 31, 2005 amends the plan document before the end of the plan year to permit a grace period ending on the 15th day of the third calendar month after the end of the plan year (March 15, 2006). Employee X timely elected a 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 a 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 16, 2006, X incurs $300 of unreimbursed medical expenses. The unused $200 from the previous plan year 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 his health FSA for the plan year ending December 31, 2006.
Same facts as in Example 1, except that X incurs $150 of medical expenses during the grace period. 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.
Run-out period. Employers may continue to provide a run-out
period after the end of the grace period, during which expenses for qualified benefits incurred during the plan year and the grace period may be paid or reimbursed.
Plan amendment needed. An employer may adopt a grace period for the current plan year (and subsequent plan years) by amending their plan documents before the end of the plan year.
<p>The IRS requires flexible benefit plans to contain an element of risk, in order to receive preferred tax treatment.</p>
What is the “use it or lose it” principle for flexible spending accounts?
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