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FSA ‘Use-It-or-Lose-It’ Rule Gets Friendly Modification
Participants to Have Grace Period on Remaining Balances

By Patricia Lawrence, Human Resources Manager

After years of congressional debate, the Internal Revenue Service and the Treasury Department issued Notice 2005-42 on May 18. This notice provides relief for many Flexible Spending Account (FSA) participants who may be able to extend the time frame for using the remaining balance on their accounts at the end of the plan year without risking forfeiture.

Old Rule Versus New Rule

Under the old FSA “Use-It-or-Lose-It” Rule, FSA participants had to spend their total annual election amount by the end of the plan year, otherwise the remaining funds became employer assets. The new rule allows participants to carry forward any FSA balances for up to two and one-half months after the end of the plan year. For example, if a participant did not use all of his FSA funds by the end of 2005, he would have until March 15, 2006, to do so. However, if the 2005 FSA balances are not used by March 15, the participant will lose those funds.

Earmarked FSA Funds

Participants may enroll in the FSA health plan, the FSA dependent care plan, or both, depending on their health and childcare needs. There are different rules for how FSA health and FSA dependent care funds may be used. The maximum annual election amount for an FSA health plan is $3,000, while annual election amount for FSA dependent care plans cannot exceed $5,000. Funds earmarked for FSA dependent care must be used for childcare expenses. Any remaining balance cannot be used for healthcare expenses. The same rule applies to any remaining balance of an FSA health plan.

Run-Out Period

Under the old rule, participants usually had up to three months into the new plan year to submit claims for expenses incurred during the preceding plan year. This time frame, known as the “run-out” period, will still apply under the new rule. Hence, participants must submit their claims for expenses incurred during the extension or grace period within a period of time designated by the plan document. Most likely, this time period will be similar to the one for the regular plan year.

What to Consider

Employers should consider several factors before moving forward with plan amendments and implementation of the new FSA rule. These factors include:

  •   Should the extension period apply to FSAs only, or to other benefits as well?
  •   Should the run-out period for the extension be the same time frame as for the normal plan year?
  •   How would the new rule impact the administrative process?
  •   What would be the additional costs to administer the new rule?

FSA Plan Amendment

If an employer or plan sponsor decides to implement the new FSA rule, they should note the following:

  •   Calendar plan-year documents must be amended to include the new rules by Dec. 31, 2005.
  •   FSA summary plan descriptions must also be amended.
  •   Implementing the new rule is not mandatory.
  •   The new rule would apply to all participants in a Cafeteria Plan or FSA Plan.
  •   The maximum grace or extension period cannot exceed two and one-half months after the end of the plan year.

If employers elect to implement the new Use-It-or-Lose-It Rule it would allow FSA participants to use FSA funds more effectively, would increase the value of FSA accounts and would continue to add to the array of innovative benefits offered to employees.