IRS Authorizes Grace Periods for Employer-Sponsored FSA Accounts

June 15, 2005

On May 18, 2005 the IRS issued Notice 2005-42 which significantly impacts reimbursement deadlines for health care expenses under employer-sponsored flexible spending accounts (FSA’s). FSAs are an employee benefit by which employees voluntarily set aside a portion of their pre-tax compensation to cover anticipated health care expenses for the following year. The IRS previously utilized a “use it or lose it rule” whereby employees automatically forfeited any unused monies remaining in their FSA accounts at the end of the plan year. The new Notice eliminates this automatic forfeiture provision and authorizes a two and one-half month grace period immediately following the end of each plan year during which unused benefits or contributions remaining at the end of the year may be paid or reimbursed to plan participants for qualified benefits expenses incurred during the grace period.

The IRS modified its rule to eliminate the year-end spending rush many participants experienced in order to avoid a forfeiture of their FSA funds. Employees may now have as long as 14 months and 15 days to use benefits or contributions rather than just the twelve months in the current plan year. This is good news for employees because they will no longer automatically forfeit unused benefits or contributions at the end of a plan year.

Employers must take certain steps to take advantage of this new grace period. First, the employer must amend the company’s plan to provide for a grace period immediately following the end of each plan year. Second, the grace period must apply to all plan participants. Third, the grace period must not extend beyond the 15th day of the third calendar month after the end of the immediately preceding plan year to which it relates. Unused benefits or contributions remaining at the end of the grace period will, however, be automatically forfeited.

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