June 23, 2005
Author: , J.D.,L.L.
On May 18, 2005, IRS released Notice 2005-42 which modifies the “use-it-or-lose-it" rule for health and dependent care flexible spending accounts. An employer may now amend its cafeteria plan document to provide for a grace period immediately following the end of each plan year of up to 2-1/2 months. The grace period must apply to all participants in the cafeteria plan. Expenses for qualified benefits incurred during the grace period may be paid or reimbursed from benefits or contributions remaining unused at the end of the immediately preceding plan year.
The effect of the grace period is that a participant may have as long as 14 months and 15 days (the 12 months in the current cafeteria plan year plus the grace period) to use the benefits or contributions for a plan year before those amounts are “forfeited” under the “use-it-or-lose-it” rule.
During the grace period, a cafeteria plan may not permit unused benefits or contributions to be cashed-out or converted to any other taxable or nontaxable benefit. Unused benefits or contributions relating to a particular qualified benefit may only be used to pay or reimburse expenses incurred with respect to that particular qualified benefit.
To the extent any unused benefits or contributions from the immediately preceding plan year exceed the expenses for the qualified benefit incurred during the grace period, those remaining unused benefits or contributions may not be carried forward to any subsequent period (including any subsequent plan year) and are “forfeited” under the “use-it-or-lose-it” rule. As under current practice, employers may continue to provide a “run-out” period after the end of the grace period, during which expenses for qualified benefits incurred during the cafeteria plan year and the grace period may be paid or reimbursed.
An employer may adopt a grace period for the 2005 cafeteria plan year (and subsequent cafeteria plan years) by amending the cafeteria plan document before the end of the 2005 plan year.
After the Notice was released, there were concerns that the grace period would have to apply to terminated participants. In conversations with Ms. Elizabeth Purcell of the IRS yesterday, the principal author of Notice 2005-42, she indicated that if an employer amended its cafeteria plan to include a grace period to active participants, that same grace period would also have apply to those former participants who extended their coverage in the Health FSA under COBRA.
Previously, if an employee had a balance in his or her Health FSA and suffered a qualifying event that terminated participation, he or she could continue participation in his or her Health FSA until the end of the year in which the qualifying event occurred if he or she had elected COBRA. Now, that former participant must be offered extended coverage through the grace period.
In addition, Ms Purcell indicated that if a employee did not continue their participation in his or her Health FSA under COBRA, the employer is not required to extend the grace period provisions to that former participant.
In further conversations with Ms. Percell, she also clarified that the amendment to the cafeteria plan to add the grace period will not be considered an allowable situation to allow participants to change (increase or decrease) their elections under either the health or dependent Care flexible spending accounts.
Mr. Percell further clarified that if an employer could also amend its cafeteria plan to either apply the cafeteria plan’s “run out” period to claims incurred during the grace period or to apply a separate “run out” period for claims incurred during the grace period (30 or 60 days after the end of the grace period).