The IRS has announced that the $2,500 annual limit on health FSAs, as imposed by 2010's health reform law, applies to the health FSA's plan year, not the participants' taxable year (the calendar year). The limit applies to plan years beginning in 2013.
The IRS guidance also makes clear that health FSAs must be amended to reflect the new limit (the amendment may wait until the last day of 2014, but the plan must operationally comply with the limit for plan years beginning in or after 2013).
Residual FSA balances carried over into a grace period do not count against the limit for the new plan year.
The limit does not apply to employer-provided flex credits that cannot be converted to cash or applied to taxable benefits, such as 401(k) plan contributions or the purchase of vacation days; few employers supply these sorts of credits under a cafeteria plan, however.
By Ed Fensholt, J.D., Health Reform Advisory Practice, Lockton Group
An IRS Notice issued May 30, does a great favor to employers sponsoring non-calendar year health flexible spending accounts (FSAs) by allowing them to implement the health reform law's $2,500 annual limit on health FSA benefits on a plan year, rather than calendar year, basis. Unfortunately, the guidance comes too late for many sponsors of non-calendar year health FSAs, who had already restricted health FSA elections to $2,500 for the 2012-13 plan year, concerned that the limit would be applied by the IRS on a calendar year basis.
The Notice also contains interesting and important nuggets for all FSAs, whether calendar year or non-calendar year. For example, all health FSAs must be amended to reflect the $2,500 limit, and there are special rules for FSA grace periods and for unique situations such as when an employee and his or her spouse are employed by the same employer and each is eligible to participate in the employer's health FSA.
The Notice also clarifies that the $2,500 restriction applies only to employee pre-tax contributions to the health FSA and to employer "flex credits" the employee may convert to cash or apply to other taxable benefits, such as 401(k) plan contributions or the purchase of additional vacation days (few employers supply these sorts of credits). The limit does not apply to employer-provided flex credits that must be used to purchase nontaxable benefits, such as health FSA benefits or health insurance.
The 2010 federal health reform law states that "an employee may not elect for any taxable year to have salary reduction contributions in excess of $2,500 made to" a health flexible spending account. The limit is indexed for inflation. The law does not state whether "taxable year" means the health FSA's plan year or the employee's taxable year, which is the calendar year. We hoped (and rather expected, at least initially) the IRS to clarify that the limit applied to the health FSA's plan year, as legislative history to the law suggested this should be the case. But there were good reasons for being wary that the IRS might not construe the law that way.
For example, the references to "employee" and "taxable year" in the same phrase seemed to suggest the restriction applied to the employee's taxable year. The health reform law, in other contexts, uses the term "taxable year" to mean the employee's taxable year. In other cases the law expressly refers to a plan's "plan year," implying that had Congress wanted the $2,500 limit to apply on a plan year basis, it would have said so. Finally, dependent care FSAs have operated under a $5,000 annual limit for many years, a limit that applies to the employee's taxable (calendar) year.
As 2012 opened, and employers sponsoring non-calendar year health FSAs began planning for open enrollments for the FSA's 2012-13 year, there was no clear answer as to whether they could apply the $2,500 limit to plan years that begin in 2013 or later. In the absence of word from the IRS, many employers whose FSA plan years begin between February and July restricted FSA elections for their 2012-13 plan years to $2,500, to help ensure that employees wouldn't contribute more than $2,500 for the 2013 calendar year, which encompasses parts of the 2012-13 and 2013-14 plan years.
Pressed by requests from the American Benefits Council and other organizations to provide relief to sponsors of non-calendar year health FSAs, the IRS delivered nicely in the Notice issued Wednesday, although the Notice comes a bit late for sponsors described in the preceding paragraph.
Limit Applies on Plan Year Basis
In its Notice the IRS says it will deem the law's reference to "taxable year" to mean the health FSA's plan year. This means that, for non-calendar year health FSAs, the $2,500 restriction does not apply until the plan year beginning in 2013. The restriction for calendar year health FSAs begins, of course, on Jan. 1, 2013.
Limit Does Not Apply to Employer-Provided Flex Credits that Cannot Be Taken as Cash or Applied to Taxable Benefits
The Notice also makes clear that the $2,500 restriction applies only to employee pre-tax salary reduction contributions (which is how the vast majority of health FSAs are funded) and to employer FSA contributions that the employee may convert to cash or apply to purchase a taxable benefit. The $2,500 restriction does not apply to employer-provided health FSA contributions or credits that may only be applied to purchase nontaxable benefits.1
The Limit's Interplay with FSA Grace Periods
The Notice provides that residual dollars in an employee's health FSA, after the close of a plan year, that the employee may draw upon during the FSA's grace period (if the FSA has one), do not count against the new year's FSA limit. For example, if an employee has $500 remaining in his or her health FSA on Dec. 31, 2012 (under a calendar year FSA), and may spend down that residual balance during a grace period that lasts until March 15, 2013, the residual $500 does not count against the employee's $2,500 limit for 2013.
Limit Applies on Employee-by-Employee Basis
The $2,500 limit applies on an employee-by-employee basis. If each of two spouses is eligible to participate in an employer's health FSA (i.e., both are eligible employees), each may elect up to a $2,500 benefit.
The Health FSA Must be Amended to Reflect the New Limit
Health FSAs must be amended to reflect the $2,500 limit (as indexed for inflation). Although the amendment is not required until Dec. 31, 2014, the FSA must comply with the limit in operation, beginning with the first day of the plan year beginning in 2013.
Oh, and before an employer considers amending its calendar year FSA to a non-calendar year FSA, to postpone by a few months the effective date of the $2,500 limit, the IRS says the amendment would be invalid. And for any new health FSA with a short plan year that begins after 2012, the $2,500 limit must be pro-rated.
If an employee, in the same year, participates in separate health FSAs maintained by separate employers but the employers are part of a controlled group of businesses, the separate FSAs are required to ensure the employee's combined FSA benefits, under the multiple FSAs, do not exceed the $2,500 limit. Ensuring compliance with this rule will be administratively difficult, but fortunately few employers will encounter such a situation.
If a cafeteria plan erroneously allows an employee to elect health FSA benefits of more than $2,500 (as indexed for inflation) for a plan year, the cafeteria plan will not risk disqualification if:
- The error results from a reasonable mistake by the employer (or the employer's agent) and is not due to willful neglect;
- Salary reduction contributions in excess of the 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 (or W-2c, if the employer needs to issue a corrected W-2) for the employee's taxable year in which ends the cafeteria plan year in which the correction is made; and
- The terms of the plan apply uniformly to all of its participants.
So Long to Use it or Lose it?
In the Notice, the IRS also solicited comments from the public on whether, in light of the $2,500 annual limit on health FSA benefits, the IRS should re-visit the need for a "use it or lose it" rule with respect to health FSAs. Coincidentally, the next day (yesterday) the House Ways and Means Committee passed a measure that would allow health FSA participants to cash out up to $500 remaining in their accounts at the end of the FSA's plan year or grace period.