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Internal Revenue Code Section 125 Cafeteria Plan Changes – "Use-or-Lose" Rule Modified and $500 Carryovers Added

Health Flexible Spending Accounts (FSAs) under Internal Revenue Code Section 125 generally permit participating employees to make pre-tax contributions to an account from which certain medical benefits may be reimbursed. Participants in FSAs elect their pre-tax contributions before the beginning of the plan year, and the so-called “use-or-lose” rule requires any contributions not used to be forfeited. Notice 2005-42 partly mitigated the forfeiture rule by allowing a plan to provide for reimbursement of certain qualifying medical expenses incurred during a grace period of two and a half months after the end of the plan year. Contributions not used during the grace period would be forfeited.

On Oct. 31, 2013, the Treasury Department and the IRS issued Notice 2013-71, which modifies the “use-or-lose” rule for FSAs and permits IRC Section 125 cafeteria plans to be amended to allow up to $500 of unused contributions remaining in FSAs at plan year end to be reimbursed to plan participants for qualified medical expenses incurred during the following year. However, a plan that permits a carryover cannot also incorporate the “grace period” rule of Notice 2005-42. So plan sponsors that wish to adopt the carryover approach must amend their plans to provide for it, and to the extent the plans contain the grace period provisions, they must be eliminated. In sum, plan sponsors may design their IRC Section 125 cafeteria plans to (1) provide for the two and a half month post-plan year grace period, (2) permit the up to $500 carryover of contributions to the next plan year, or (3) not permit either a grace period or a carryover.

The up to $500 carryover option will not affect the maximum annual employee contribution of $2,500 for health FSAs imposed under the Patient Protection and Affordable Care Act effective for plan years beginning in 2013. However, no more than $500 can be carried over from one year to the next. The carryover option is not meant to permit for the accumulation of funds in accounts on a pre-tax basis.

Amendments to incorporate the carryover option must be adopted on or before the last day of the plan year from which amounts may be carried over and may be effective retroactively to the first day of that plan year. However, for such an amendment to be properly adopted, plan participants must be informed of the new provisions and the plan must be operated in accordance with the guidelines of Notice 2013-71. A special rule postpones the deadline for amendments for any plan year that starts in 2013 to the end of the plan year that starts in 2014.

The carryover option may temper the reluctance of moderate-income employees to participate in cafeteria plans because even modest forfeitures might pose a hardship. Additionally, the carryover option may counteract the tendency of plan participants to spend their contributions on potentially wasteful expenditures by plan year end.

© 2022 BARNES & THORNBURG LLPNational Law Review, Volume III, Number 314
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About this Author

Mina Amir-Mokri, Barnes and Thornburg Law Firm, Chicago, Corporate and Labor and Employment Law Attorney
Partner

Mina Amir-Mokri is a partner in Barnes & Thornburg LLP’s Chicago office and is a member of the Corporate Department. Ms. Amir-Mokri focuses her practice in the areas of employee benefits and executive compensation. She has represented executives, public and private companies, tax exempt organizations and various bankruptcy constituencies in the negotiation, design, and drafting of executive compensation arrangements, stock option and other equity plans, retirement plans, employment and other related agreements. Ms. Amir-Mokri has represented clients in challenges to executive...

312-214-4804
Brian J. Lake, Barnes Thornburg Law Firm, South Bend, Corporate Law Attorney
Of Counsel (Retired)

Brian J. Lake is retired of counsel in the Corporate Department in the South Bend, Indiana, office of Barnes & Thornburg LLP. His career spanned more than 30 years of experience in counseling and advising businesses to help them deal with a wide spectrum of legal issues and business transactions. He worked closely with business owners to help achieve creative legal solutions that enabled businesses to take advantage of opportunities in the marketplace and be successful from one generation to the next.

Mr. Lake worked closely with a wide...

574-237-1155
Michael G. Paton Corporate and Employment Law Attorney Barnes Thornburg Law Firm Indianapolis
Partner

Michael G. Paton is a partner with Barnes & Thornburg LLP, resident in the firm’s largest office in Indianapolis, Indiana where he is a member of the Corporate Department and Chairman of the Compensation and Employee Benefits Practice Group. For over 25 years he has concentrated his practice on the many legal issues surrounding employee benefits. His “full service” practice encompasses a broad spectrum of activities, including drafting and design of both qualified and non-qualified retirement plans, cash balance and other "hybrid" plans, 401(k) plans and employee stock ownership plans...

317-231-7201
John Smarella Attorney Barnes & Thornburg Law Firm
Partner

John C. Smarrella is a partner in the Corporate Department in the South Bend, Indiana office of Barnes & Thornburg LLP and is a member of the firm’s Renewable Energy and Entrepreneurial Services Practice Groups. He concentrates his practice on corporate matters and has considerable experience in acquisitions and dispositions of business entities, joint ventures and other business collaborations. His practice also includes advising closely-held companies on a variety of business matters, including succession planning, long-term supply, manufacturing, licensing and other agreements, tax...

574-237-1133
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