IRS offers "use it or lose it" grace period for flexible spending accounts.

The IRS has announced in Notice 2005-42 that it will allow a fexible spending plan (FSA) to be amended to create up to a 2-1/2 month grace period beginning with the 2005 plan year or unused FSA credits that would otherwise have to be forfeited under the "use it or lose it" rule. These unused credits can be used to pay expenses incurred in the first 2-1/2 months of the following plan year. This would allow an employee to spend his credits for any particular year on expenses incurred over a period of up to 14-1/2 months instead of just 12. Any remaining unused credits from the prior year would then be forfeited.

By example, the IRS describes a situation where the employee elected $1,000 under the health FSA for 2005 and had $200 remaining unused at 12/31/05. He then had $300 of expenses incurred from 1/1/06 through 3/15/06. The unused $200 from 2005 could be applied against the $300 in 2006 expenses before the 2006 credits were touched.

The Notice makes it clear that if the first 21/2 month's expenses n the following year are less than the remaining unused credits from the prior year, the difference would be forfeited. So, in the example, if the expenses incurred from 1/1/06 through 3/15/06 were only $150, they could be paid from the $200 of unused 2005 credits, but the remaining $50 would then be forfeited.

The new grace period is different from the rule that allows expenses from a given year to be paid out of that year's contributions, even though they are presented for payment after the end of that year (commonly referred to as "run off"). The new grace period actually allows a given year's unused contributions to be used for expenses incurred early in the next year. Plans that allow for a run off period and want to offer the new grace period, as well, will have to monitor claims during the early part of a plan year to ensure that prior year contributions are used first to reimburse prior year claims. While last year's contributions can be used to pay the next year's expenses under the grace period, this year's contributions may not be used for last year's run off.

In order to take advantage of this relief for the 2005 plan year, the plan must be amended by the end of this year. Also, credits from different types of plans can't be mixed (i.e., unused health FSA credits can't be used for dependent care, and vice versa). The IRS has informally indicated that an employer can apply the grace period separately to dependent care and health FSAs.

There are issues that still need to be sorted out, and we expect further guidance from the IRS, especially in regard to the impact of the grace period on employers that offer health savings accounts in conjunction with a high deductible health plan.

Richard P. Selden is Senior VP & Director of Legal Services, Core Benefits for USI Consulting Group. For more information, please contact Peter Winter, EVP, Employee Benefits Practice Leader or Robert Corenson, VP at USI of Southern California Insurance Services Inc. in Sherman Oaks.