The IRS has recently announced an increase to FSA Maximum limits that employers should be aware of. The Affordable Care Act (ACA) imposes a $2,500 limit on salary reduction contributions to a health flexible spending account (FSA) offered under a cafeteria plan, effective for plan years beginning on or after Jan. 1, 2013. This limit is applicable to grandfathered and non-grandfathered health FSAs.
Prior to the ACA change, the law did not limit employees’ health FSA contributions. It had been common, however, for employers to limit employee contributions to health FSAs. Employers may continue to impose limits on employee health FSA contributions, as long as the employer’s limit does not exceed the ACA’s maximum limit.
Alltrust strives to provide you knowledge and guidance regarding compliance issues surrounding employee benefits. Please see the additional information below regarding the IRS announcement to increase the FSA maximum limit. If you have questions, please contact an Alltrust Specialist.
EFFECTIVE DATE OF FSA MAXIMUM LIMIT
The ACA provides that the health FSA limit is effective for taxable years beginning after Dec. 31, 2012. Because the ACA ties the effective date to the taxable year, and not specifically to the plan year, there was some confusion regarding when the limit became effective for non-calendar year plans.
In Notice 2012-40, the IRS clarified the effective date of the $2,500 FSA limit. The IRS Notice states that the $2,500 FSA limit does NOT apply for plan years that begin before 2013. Instead, the IRS clarified that the limit applies on a plan year basis and is effective for plan years beginning after Dec. 31, 2012. Thus, for a calendar year plan, the limit became effective on Jan. 1, 2013.
This guidance has the most significant impact on non-calendar year cafeteria plans. Under the IRS’s interpretation of the law, a health FSA with a July 1 plan year was not required to comply with the ACA’s limit until the plan year beginning July 1, 2013. Having the health FSA limit tied to the plan year, and not to an individual’s taxable year, simplifies the administration of this limit for non-calendar year plans.
If a cafeteria plan has a short plan year (that is, fewer than 12 months) that begins after 2012, the $2,500 limit must be prorated based on the number of months in that short plan year.
The $2,500 health FSA limit is indexed for cost-of-living adjustments for years after 2013.
In Revenue Procedure 2013-35, the IRS announced annual inflation adjustments for 2014 for a number of tax provisions, including the health FSA limit. According to this guidance, for the taxable years beginning in 2014, the dollar limitation on employee salary reductions contributions to health FSAs remains unchanged at $2,500.
On Oct. 30, 2014, the IRS released Revenue Procedure 2014-61, which includes the annual inflation numbers for 2015 for a number of tax provisions, including the health FSA limit. According to this guidance, for taxable years beginning in 2015, the dollar limitation on employee salary reduction contributions to health FSAs will increase to $2,550, up $50 from the amount for 2014.
The health FSA limit potentially will be further increased for cost-of-living adjustments for later years.
PER EMPLOYEE LIMIT
The health FSA limit applies on an employee-by-employee basis. Each employee may elect only up to $2,500 in salary reductions, regardless of whether or not he or she also has family members who benefit from the funds in that FSA.
However, each family member who is eligible to participate in his or her own health FSA will have a separate limit. For example, a husband and wife who have their own health FSAs can both make salary reductions up to $2,500 per year (subject to any lower employer limits).
If an employee participates in multiple cafeteria plans that are maintained by employers under common control, the employee’s total health FSA salary reduction contributions under all of the cafeteria plans are limited to $2,500. However, if an individual has health FSAs through two or more unrelated employers, he or she can make salary reductions up to $2,500 under each employer’s health FSA.
SALARY REDUCTION CONTRIBUTIONS
The ACA imposes the $2,500 limit on health FSA salary reduction contributions. Non-elective employer contributions to a health FSA (for example, matching contributions or flex credits) generally do not count toward the $2,500 limit. However, if employees may elect to receive the employer contributions in cash or as a taxable benefit, then the contributions will be treated as salary reductions and will count toward the $2,500 limit.
In addition, the limit does not impact contributions under other employer-provided coverage. For example, employee salary reduction contributions to an FSA for dependent care assistance or adoption care assistance are not affected by the $2,500 health FSA limit. The limit also does not apply to salary reduction contributions to a cafeteria plan that are used to pay for an employee’s share of health coverage premiums, to contributions to a health savings account (HSA) or to amounts made available by an employer under a health reimbursement arrangement (HRA).
A cafeteria plan may include a grace period of up to two months and 15 days immediately following the end of a plan year. If a plan includes a grace period, an employee may use amounts remaining from the previous plan year, including amounts remaining in a health FSA, to pay for expenses incurred for certain qualified benefits during the grace period. If a health FSA is subject to a grace period, unused salary reduction contributions that are carried over into the grace period do not count against the $2,500 limit applicable to the following plan year.
A cafeteria plan with a health FSA must be amended to include the ACA’s $2,500 limit (or a lower limit at the employer’s option). In general, cafeteria plan amendments cannot be made retroactively. However, the IRS sometimes provides exceptions to this rule. Cafeteria plans with health FSAs must be amended for the ACA’s $2,500 limit on or before Dec. 31, 2014. To take advantage of the delayed amendment deadline, the cafeteria plan must comply in operation with the ACA’s limit for health FSAs for plan years beginning after Dec. 31, 2012.
Compliance relief is provided for certain salary reduction contributions exceeding the $2,500 limit that are due to a reasonable mistake and not willful neglect and that are corrected by the employer. More specifically, if one or more employees are mistakenly allowed to elect a salary reduction of more than $2,500 for a plan year, the error may be corrected without causing the cafeteria plan to lose its preferential tax status if:
- The plan’s terms apply uniformly to all participants;
- The error results from a reasonable mistake by the employer (or its agent) and is not due to the employer’s (or agent’s) willful neglect; and
- Salary reductions in excess of the $2,500 limit are paid to the employee and reported as wages for income tax withholding and employment tax purposes on the employee’s Form W-2.
The “use-or-lose” rule generally prohibits any contribution or benefit under a health FSA from being used in a following plan year or period of coverage. According to the IRS, the $2,500 limit reduces the potential for using health FSAs to defer compensation and limits the extent to which salary reduction amounts may accumulate over time.
On Oct. 31, 2013, the IRS released Notice 2013-71 (Notice), which relaxes the “use-or-lose” rule for health FSAs. Under the relaxed rule, employers will now be able to allow participants to carry over up to $500 in unused funds into the next year. This modification applies only if the plan does not also incorporate the grace period rule.
The IRS decided to change the “use-or-lose” for a number of reasons, including:
- Difficulty for employees in predicting their future needs for medical expenditures;
- Minimizing unnecessary spending at the end of a year or grace period;
- The possibility that lower- and moderate-paid employees are reluctant to participate in an FSA because of the risk of losing salary reduction contributions; and
- The opportunity to ease and potentially to simplify the administration of health FSAs.
Under the modified rule, an employer, at its option, is permitted to amend its section 125 cafeteria plan document to allow up to $500 of unused amounts remaining at the end of a plan year in a health FSA to be paid or reimbursed to plan participants for qualified medical expenses incurred during the following plan year. The plan may specify a lower amount as the permissible maximum (and has the option of not permitting any carryover at all). As noted above, this modification applies only if the plan does not also incorporate the grace period rule.
The carryover of up to $500 may be used to pay or reimburse medical expenses under the health FSA incurred during the entire plan year to which it is carried over. For this purpose, the amount remaining unused as of the end of the plan year is the amount unused after medical expenses have been reimbursed at the end of the plan’s run-out period for the plan year. A cafeteria plan may not allow unused amounts to be cashed out or converted to any other taxable or nontaxable benefit.
If an employer amends its plan to adopt a carryover, the same carryover limit must apply to all plan participants. A cafeteria plan is not permitted to allow unused amounts relating to a health FSA to be cashed out or converted to any other taxable or nontaxable benefit.
With respect to a participant, the amount that may be carried over to the following plan year is equal to the lesser of:
- Any unused amounts from the immediately preceding plan year; or
- $500 (or a lower amount specified in the plan).
Any unused amount in excess of $500 (or a lower amount specified in the plan) remaining at the end of the run-out period for the plan year is forfeited. Any unused amount remaining in an employee’s health FSA as of termination of employment also is forfeited (unless, the employee elects COBRA coverage with respect to the health FSA).
Effect on the $2,500 Limit and Grace Period
This new carryover does not affect the $2,500 limit on salary reduction contributions. This means the plan may permit the individual to elect up to $2,500 in salary reductions in addition to the $500 that may be carried over.
According to the IRS, this carryover option provides an alternative to the current grace period rule and administrative relief similar to that rule. A plan adopting this carryover provision may not also provide a grace period with respect to health FSAs. Also, for any plan year, the plan may not:
- Allow an individual to salary reduce for qualified health FSA benefits more than the indexed $2,500 salary reduction limit; or
- Reimburse claims incurred during the plan year that exceed the $2,500 salary reduction limit (and any non-elective employer flex credits) plus the carryover amount of up to $500.
The Uniform Coverage Rule
The uniform coverage rule, which requires that the maximum amount of reimbursement from the health FSA be available for claims incurred at all times during the period of coverage, continues to apply for plans adopting the $500 carryover.
For ease of administration, a cafeteria plan is permitted to treat reimbursements of all claims for expenses that are incurred in the current plan year as reimbursed first from unused amounts for the current plan year and, only after exhausting these current plan year amounts, as then reimbursed from unused carryover amounts from the preceding plan year.
- Any carryover amounts that are used to reimburse a current year expense:
- Reduce amounts available to pay prior plan year expenses during the run-out period;
- Must be counted against the permitted carryover of up to $500; and
- Cannot exceed the permitted carryover.
The Notice also includes examples of how the carryover operates.
Written Cafeteria Plan Amendment Required
To implement the new $500 carryover option, a cafeteria plan offering a health FSA must be amended to include the carryover provision.
The amendment 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, provided that:
- The cafeteria plan operates in accordance with the rules in the Notice and informs participants of the carryover provision; and
- A plan may be amended to adopt the carryover provision for a plan year that begins in 2013 at any time on or before the last day of the plan year beginning in 2014.
If a plan has provided for a grace period and is being amended to add a carryover provision, the plan must also be amended to eliminate the grace period provision by no later than the end of the plan year from which amounts may be carried over. The ability to eliminate a grace period provision previously adopted for the plan year in which the amendment is adopted may be subject to non-Code legal constraints.