IRS allows $500 carryover for unused healthcare FSAs
December 13, 2013
Article courtesy of SBAM Approved Partner AdvanceHR
Flexible spending accounts (FSAs) recently became a little more flexible. That’s because the IRS modified its “use or lose” rule, which returns any unused FSA balances back to employers at year-end. Now employers can elect to allow plan participants to carryover up to $500 of their unused healthcare FSA balances into the following year. This election is not a sure win. Like many IRS rules, there’s a catch to the $500 carryover privilege.
The IRS just announced a new exception to the longstanding “use or lose” rule for healthcare flexible spending account (FSA) plans. Under the exception, if you have an unused balance in your FSA at the end of the plan year, you can carry over up to $500 of that unused balance to the following year.
Without such a carryover privilege, any unused balance is forfeited to your employer under the use-or-lose rule. Bottom line: The ability to carry over an unused balance is a big help for those who over-estimate their out-of-pocket medical expenses for the year. But an employer must amend its plan to offer the new carryover privilege. Otherwise, nothing changes.
This article explains the new carryover privilege, after first covering some necessary background information.
Healthcare FSA Basics
Under a healthcare FSA plan, you make an election to contribute a designated amount of your salary to your personal healthcare FSA. The maximum amount you can contribute for both 2013 and 2014 is $2,500 per year.
Your contribution is withheld in installments from your paychecks. Throughout the year, you can use the FSA money to reimburse yourself for out-of-pocket medical expenses, such as amounts paid to satisfy health insurance deductibles and co-pays, as well as amounts paid for prescription drugs, dental care, and vision care. The contribution withheld from your paychecks is treated as a salary reduction for federal income, Social Security and Medicare tax purposes. It’s usually a salary reduction for state tax purposes, too. Reimbursements from the FSA to cover qualified out-of-pocket medical expenses are tax-free to you.
To put it another way, the healthcare FSA arrangement allows you to pay for all or a portion of your out-of-pocket medical expenses with pretax dollars. That is the same as getting an income tax deduction combined with a reduction in your Social Security and Medicare tax withholding. The tax savings are permanent — not just a timing difference.
The only downside to the FSA deal is the use-or-lose rule. If you fail to incur enough qualified medical expenses to drain your healthcare FSA each year, any leftover balance generally goes back to your employer. In other words, before the new $500 carryover privilege, the use-or-lose rule meant you could never carry over any unused healthcare FSA balance to the following year. That money was just lost.
However, some plans currently allow a grace period of up to 2 1/2 months to ease this concern. If so, you have until March 15 of the following year to incur enough expenses to soak up your unused healthcare FSA balance from the previous year. But if there is still an unused balance at the end of the grace period, that money is gone forever.
The new $500 unused balance carryover privilege is an alternative to — rather than an addition to — the grace period deal. So, your company’s healthcare FSA can offer either the new carryover privilege or the familiar grace period, but not both.
New Healthcare FSA Carryover Option
Thankfully, the IRS has now given employers the option of amending their healthcare FSA plans to allow a carryover of up to $500 of any balance that remains unused at the end of any plan year. Any unused balance in excess of the $500 limit is forfeited.
Subject to the $500 limit, the carryover privilege can be used to cover qualified out-of-pocket medical expenses incurred any time during a subsequent plan year. The carryover amount does not count against or reduce the healthcare FSA contribution cap for the subsequent year ($2,500 for 2014). If desired, your company can specify a lower carryover limit than the $500 maximum. In any case, the same carryover limit must apply to all participating employees.
A plan that has a carryover provision cannot also provide a grace period that falls within the plan year to which unused amounts can be carried over. For example, a calendar-year healthcare FSA plan that is amended to permit a carryover to 2014 of unused 2013 balances (up to the $500 limit) cannot have a grace period that extends into 2014. However, a calendar-year plan that does not allow a carryover until 2015 (of unused 2014 balances) can have a grace period for the 2013 plan year that extends through as late as March 15, 2014.
Deadlines for Plan Amendments
To adopt the new unused balance carryover privilege, your company must amend its healthcare FSA plan by no later than the last day of the plan year from which amounts may be carried over. However, for plan years that begin in 2013, the IRS will allow the amendment to be made at any time up to the last day of the plan year that begins in 2014. Therefore, a calendar year FSA plan — which most plans are — can be amended by as late as December 31, 2014 to allow the unused balance carryover privilege for unused balances from the 2013 plan year.
If a healthcare FSA plan currently provides for a grace period and is being amended to add the new carryover deal, the plan must be amended to eliminate the grace period by no later than the end of the plan year from which amounts may be carried over. Therefore, a calendar-year plan that currently includes a grace period, and that will be amended to adopt the carryover privilege or unused balances from the 2013 plan year, must be amended to eliminate the grace period provision by no later than December 31, 2013.
What’s the Catch?
The new carryover privilege for unused healthcare FSA balances is a welcome improvement to FSA plans in the eyes of most employees. But employers must amend FSA plans for employees to benefit. The primary downside to adopting the carryover privilege is the requirement to eliminate any existing grace period provision. Contact your tax adviser or employee benefits adviser to learn more.
Example: See How the $500 Carryover Privilege Works
Suppose your employer offers a calendar-year healthcare FSA plan. During the open-enrollment period each November, employees can elect to make healthcare FSA salary reduction contributions of up to $2,500 for the following plan year. Your company plan is amended to allow a carryover of up to $500 of unused healthcare FSA balances that remain at the end of each plan year, starting with the 2013 plan year. The plan is also amended to eliminate the 2 1/2 month grace period that was previously allowed.
In November of 2012, you elected to make a $2,500 salary-reduction contribution for the 2013 healthcare FSA plan year. Because your out-of-pocket medical expenses turned out to be lower than expected, your healthcare FSA has an unused balance of $450 at the end of the 2013 plan year. Thanks to the new carryover privilege, the $450 is carried over to the 2014 plan year and is available to cover out-of-pocket medical expenses incurred next year.
If you elect in November 2013 to make another $2,500 healthcare FSA contribution for the 2014 plan year, your initial balance for the 2014 plan year will be $2,950 ($2,500 from the 2014 salary-reduction contribution plus the $450 carryover from 2013).
Say you incur $2,650 of out-of-pocket medical expenses during the 2014 plan year. Your unused balance at the end of the plan year is $300 ($2,950 initial balance minus $2,650 equals $300). The $300 is carried over to the 2015 plan year and is available to cover out-of-pocket medical expenses incurred in 2015.