Important IRS Guidance Allows a Second Chance for Flexible Spending Account Participants Before Application of “Use It or Lose It” to Unspent Funds

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May 19, 2005

On May 18, 2005, the IRS issued a notice which provides significant relief from the “use it or lose it” rule which applies to amounts set aside in flexible spending accounts. Prior to this new guidance, only expenses incurred during the plan year could be reimbursed from dependent care and medical reimbursement flexible spending accounts in a cafeteria plan, and if amounts remained after all eligible expenses were reimbursed, the plan participant forfeited the excess under the “use it or lose it rule.”

Effective immediately, if the cafeteria plan document is amended to so provide, plan participants would have a grace period of up to two and 1/2 months after the end of the plan year during which unused flexible spending account monies can be used to reimburse expenses during the grace period. In effect, this gives participants up to 14 months and 15 days to spend down flexible spending account balances, which were built up over the 12 month plan year. Note that this grace period is different from the runoff period that many cafeteria plans offer, allowing participants a period of time after the plan year to submit expenses incurred prior to the last day of the plan year for reimbursement.

As an example, a cafeteria plan participant who has $200 remaining in her medical reimbursement flexible spending account as of December 31, 2005 can spend down that balance by incurring eligible expenses through March 15, 2006. If the same participant has made an election to contribute to her medical reimbursement flexible spending account for the 2006 plan year, expenses incurred from January 1, 2006 through March 15, 2006 would first be applied against the $200 remaining from the 2005 plan year, and then be applied to the account balance for the 2006 plan year.

The IRS guidance makes it clear that 1) cafeteria plans must be amended to allow this additional grace period and 2) any amounts remaining after reimbursement of all eligible expenses incurred during the plan year plus the grace period must be forfeited under the use it or lose it rule. That is, the grace period is not intended as a way to allow excess amounts to be paid out in cash. The guidance is also clear that plan amendments can still be effective for the 2005 plan year which for most employers has already begun.

If you sponsor a cafeteria plan with flexible spending accounts and would like to give your employees this extended grace period to incur qualifying expenses and avoid the harshness of the use it or lose it rule, Ruder Ware can assist you in drafting the necessary plan amendments and updating summary plan descriptions. If you have questions regarding the above, please contact Mary Ellen Schill, the author of this article, or any of the attorneys in the Employment, Benefits & Labor Relations Practice Group of Ruder Ware.

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