The IRS has recently (and somewhat unexpectedly) released Notice 2005-42. The Notice provides that the year-end "use-it-or-lose-it" deadline for incurring expenses under a flexible spending account (FSA) can be extended by a two-and-one-half-month grace period. As a result, any unused benefits or contributions remaining from the prior year may be used to reimburse participants for qualified expenses incurred during the grace period. For example, Employee X has $100 remaining in her FSA at the end of the year and incurs a $100 qualified expense in January of the following year; Employee X can now apply the unused $100 towards the expense incurred in January, provided the plan has been amended to permit the grace period.
As a matter of background, cafeteria plans (sometimes called 125 plans, flexible benefit plans, flex plans, or flexible benefit arrangements) allow employees to pay for qualified benefits on a pre-tax basis. Qualified benefits include employer-provided accident and health plans, group-term life insurance, FSAs, dependent care assistance programs, and adoption assistance programs. A cafeteria plan cannot be structured to defer the receipt of compensation or operate in a way that enables participants to defer compensation to a subsequent plan year. This is commonly referred to as the "use-it-or-lose-it" rule, which requires that unused contributions or benefits remaining at the end of the plan year be forfeited.
The new rule will likely affect the annual year-end rush to use up FSA accounts. Under the prior rule, any unspent funds remaining at the end of the year are forfeited. Under the new rule, employers may amend their plans to extend the deadline for reimbursements during the grace period. To take advantage of this change, it is important to note that the employer's plan will ordinarily need to be amended before the end of the current plan year.
If the unused benefits or contributions from the preceding plan year exceed the expenses incurred during the grace period, the remaining unused benefits or contributions may not be carried forward to any subsequent period or plan year and are forfeited. However, 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 submitted for reimbursement.
The IRS is expected to issue more formal guidance and modify the related current proposed regulations. As a result, employers should have adequate time to amend their plans before the end of the plan year to take advantage of the change in the rules.