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IRS rule allowing flexible spending account carry-overs has pros and cons for employers

Originally posted November 17, 2013  by Jerry Geisel on http://www.businessinsurance.com

Employers have a new option to reduce the likelihood that employees will forfeit contributions to their flexible spending accounts, but companies need to evaluate the pros and cons of the approach before deciding whether to adopt the new “carry-over” design.

The option, which the Internal Revenue Service and the Treasury Department announced last month, allows employees to carry over up to $500 in FSA contributions remaining at the end of a plan year to use in the next plan year.

That is an alternative to the modification of the 1984 IRS use-it-or-lose-it rule, which requires FSA participants to forfeit money remaining in their accounts at the end of a plan year. Under the 2005 modification, employers can establish “grace-period” FSAs that allow employees to roll over the entire unused account balance to pay for expenses incurred during the first 21/2 months of the next plan year before the money is forfeited.

Grace-period FSAs are used by more than 40% of employers that offer an FSA, according to consultant Aon Hewitt.

After a year of examining the issue, federal regulators approved the new carry-over approach. However, employers can use either grace-period or carry-over FSAs, but not both. Employers also can continue to offer standard FSAs in which unspent balances are forfeited at the end of a plan year.

The carry-over approach also does not affect the $2,500 limit on annual FSA contributions imposed by the 2010 health care reform law.

The carry-over approach will cut back on “wasteful year-end FSA health care spending by limiting the risk of forfeiture and, in turn, reducing the incentive to spend down as year-end approaches in order to avoid losing unused funds,” the Treasury Department said in a statement when it unveiled the alternative.

At least some employers are expected to adopt carry-over FSAs.

“We will see some movement” to the carry-over approach, said Nicole Wruck, a senior director and health and welfare practice leader with Aon Hewitt in Lincolnshire, Ill. “It seems like a win for many participants.”

“You won’t have this rush to spend at the end of the year. Employees will be more careful about spending” FSA account balances, said Jody Dietel, chief compliance officer for WageWorks Inc., a San Mateo, Calif.-based FSA administrator.

“My best guess is that employers will feel this approach is an enhancement that employees will welcome,” said Michael Thompson, a principal with PricewaterhouseCoopers L.L.P. in New York.

But others say employees who anticipate major health care expenses early in a plan year, such as orthodontia, could be losers under a carry-over FSA approach.

Andy Anderson, a partner at law firm Morgan, Lewis & Bockius L.L.P. in Chicago, said with a grace-period FSA, an employee could roll over up to $2,500 and have up to $5,000 to pay major health care expenses early in the next plan year. By contrast, the employee would have a maximum of $3,000 to use in the next plan year under a carry-over FSA.

A potential disadvantage for employers in the carry-over FSA approach is that forfeitures on unused balances could decrease significantly. That could cost employers because many use forfeitures to offset administrative expenses incurred in offering FSA programs, experts say.

“There is likely to be less to offset expenses,” said Jay Savan, a partner with Mercer L.L.C. in Atlanta.

Pending additional regulatory guidance, several unknowns remain involving the interaction of carry-over FSAs and rules affecting contributions to health savings accounts.

Under IRS rules, contributions to HSAs are not allowed when employees are enrolled in general-purpose FSAs. However, when the IRS authorized grace-period FSAs, it said HSA contributions would be allowed during the grace period by converting to a limited-purpose FSA in which balances could be used only to pay for dental, vision and preventive care services.

While consultants say IRS officials have informally said that HSA contributions could be made for individuals with carry-over FSAs — so long as the FSA was amended to be limited purpose — there has been no official guidance.

“The current guidance does not address this, so employers need to tread carefully” said Rich Stover, a principal with Buck Consultants L.L.C. in Secaucus, N.J.