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FSA use-it-or-lose-it rule could be modified by IRS

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FSA use-it-or-lose-it rule could be modified by IRS

WASHINGTONThe Internal Revenue Service has eliminated a compliance problem arising from a health care reform law that imposed a flexible spending account contribution cap and is considering an even bigger change: modifying its longtime use-it-or-lose-it rule for FSAs.

Much to employers' relief, the IRS last week said the $2,500 annual FSA contribution cap set by the Patient Protection and Affordable Care Act will not apply for plan years that begin before Jan. 1, 2013.

With that simple statement, the IRS, in Notice 2012-40, eliminated a compliance problem that loomed for thousands of employers with noncalendar-year or fiscal-year FSAs.

Prior to the health care reform law that imposed the $2,500 cap effective Jan. 1, 2013, there was no limit on how much employees could contribute to their FSAs. Employers, though, typically limited annual contributions to $4,000 to $5,000.

The compliance problem was brought home in a letter that the American Benefits Council sent in April to federal regulators. The letter cited the example of an employee in an FSA with a fiscal year that begins on July 1, 2012. The employee elected to contribute $3,600 during the plan year, making contributions of $300 a month from July 1, 2012, through June 30, 2013.

However, if the employee elected to contribute $2,500 for the next plan year starting July 1, 2013, that would violate the cap for the 2013 calendar year, the ABC noted. That is because the employee would have contributed $300 a month for the first six months and $208.33 for the last six months of 2013, for a 2013 total of $3,050, violating the $2,500 limit.

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By clarifying that the $2,500 FSA limit begins for plans year that begin on or after Jan. 1, 2013, employees in noncalendar-year plans that begin this year will be exempt from the limit through the end of the plan year.

“This is the right approach. It avoids complexities and confusion,” said Paul Dennett, ABC's senior vp-health care reform in Washington.

Regulators “listened to reason,” said Gretchen Young, senior vp-health policy with the ERISA Industry Committee in Washington.

In the same notice, the IRS cleared up another FSA issue. It said any amounts that remain in what are called grace period FSAs can be rolled over to the next plan year without those funds counting against the $2,500 limit. Grace period FSAs—allowed by the IRS under a 2005 rule—are those in which unused balances from the prior plan year can be used to pay expenses that are incurred during the first 2.5 months of the next plan year.

“The IRS has cleared up uncertainty on the grace period issue,” said Rich Stover, a principal with Buck Consultants Inc. in Secaucus, N.J.

Even bigger FSA changes may be ahead.

The IRS said it will consider modifications to its 28-year-old use-it-or-lose-it rule that requires plan participants to use contributions by the end of the plan year—or by the end of the grace period, if the employer has one—or forfeit the money.

The $2,500 FSA cap in the reform law “limits the potential for using health FSAs to defer compensation,” the IRS said in explaining why it will consider modifying the rule.

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Benefit experts say there are good public policy reasons to scrap the use-it-or-lose-it rule.

The fear of forfeiting the money at the end of a plan year causes some employees to use health care services that they don't need, experts say.

“If we want to bend the cost curve, we want to discourage unnecessary spending,” said Jody Dietel, chief compliance officer at WageWorks Inc., a San Mateo, Calif.-based FSA administrator.

If unused funds could be rolled over for use the next year, for example, that incentive to spend balances at year-end to avoid forfeitures would be eliminated, experts say. The use-it-or-lose-it rule also discourages some employees from contributing more to FSAs or not contributing at all, resulting in the loss of a tax-favored way to pay for health care expenses, Ms. Dietel said.

While it was not clear whether the IRS would eliminate or modify the 28-year-old rule, experts say one approach the IRS might consider is allowing unused amounts to roll over year after year with a limit being imposed on maximum accumulation.