IRS Relaxes Health Reform Law $2,500 Limit for Noncalendar-Year FSAs

Employer benefits lobbying groups complained that the limit would effectively force noncalendar-year plans to comply with the rule before the statutory effective date.

May 31, 2012

The Internal Revenue Service on May 30 provided regulatory relief for health care flexible spending account participants and also said it is reconsidering its longtime use-it-or-lose-it rule for FSAs.

Under that relief, the IRS said participants in noncalendar-year plans can still make the maximum contributions to their FSAs during the first year that a mandated FSA contribution cutback goes into effect under the health care reform law.

The issue involves a provision in the Patient Protection and Affordable Care Act, which goes into effect on Jan. 1, 2013. Under that provision, the maximum annual contribution employees can make to their FSAs will be $2,500. Under current law, there is no annual limit, though employers typically limit annual contributions to $4,000 to $5,000.

Employer benefits lobbying groups complained that the limit would effectively force noncalendar-year plans to comply with the rule before the statutory effective date.

In a letter sent earlier to federal regulators, the American Benefits Council cited the example of an employee in an FSA with a fiscal year that begins on July 1, 2012. The employee elects to contribute $3,600 during that plan year, making contributions of $300 a month from July 1, 2012, through June 30, 2013. FSAs typically are designed so employees make level contributions during the plan year.

If the employee elects to contribute $2,500 for the next plan year starting July 1, 2013, the employee would violate the $2,500 annual limitation for 2013, the ABC noted. That is because the employee would have contributed $300 a month for the first six months of 2013 and $208.33 for the last six months of 2013. That total contribution of $3,050 would violate the $2,500 statutory limit for 2013.

In Notice 2012-40, the IRS eliminated that problem. Specifically, the IRS said the $2,500 limit will not apply for plan years that begin before 2013.

"This was a very serious issue. The IRS notice is very positive for employers with noncalendar-year plans," said Rich Stover, a principal with Buck Consultants L.L.C. in Secaucus, New Jersey.

In addition, the IRS made clear that amounts that remain in so-called grace period FSAs can be rolled over to the next 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 for the grace period issue," Stover said.

In a development that stunned benefit experts, the IRS also disclosed Wednesday in Notice 2012-40 that it considering "modifying" its 28-year-old use-it-or-lose-it rule.

The $2,500 contribution in the health care reform law "limits the potential for using health FSAs to defer compensation," the IRS said.

"They (regulators) are talking about the potential demise of use-it-or-lose-it," said Andy Anderson, a partner with Morgan Lewis & Bockius L.L.P. in Chicago.

If use it or lose it were eliminated, FSAs would become even more popular, said Michael Thompson, a principal with PricewaterhouseCoopers L.L.P. in New York. The fear of losing unused contributions is a disincentive for some employees to participate, and others contribute less than they would in the absence of the requirement, experts said.