IRS EXTENDS USE-IT-OR-LOSE-IT FSA DEADLINE

By Mark J. Kovaleski, CPA

The year-end deadline for flexible spending accounts (FSAs) has been extended by a two and a half month grace period, according to the Internal Revenue Service (IRS) Notice 2005-42.

History

An FSA can be adopted by a plan sponsor, which allows employees to save for non-reimbursed medical expenses or dependent care costs on a pre-tax basis.  Before the beginning of each year, an employee elects an annual amount for both qualified health and qualified dependent care expenses that will be deferred from the employee’s compensation an a payroll period basis.  Because taxes aren’t calculated on the contributions, the actual hit to your paycheck will be less than the amount set aside.  For example, a $100 per-pay period contribution might reduce a paycheck by only $75 because a smaller amount of tax is withheld.

As qualified expenses are incurred, the employee can submit for reimbursement of the qualified expense at any time during the plan year up to the annual amount selected   This amount is subject to reimbursement maximums and other reasonable conditions.  In order for employees to enjoy the tax deferral under these arrangements, FSAs have a use-it-or-lose-it feature.  This means that in the event that an employee does not incur qualified expenses that equal or exceed the annual amount selected during the plan year, or if the employee neglects to request reimbursement of qualified expenses incurred prior to the deadline date imposed by the employer, than any unpaid balance in the employee’s FSA account is forfeited.  In order for a qualified expense to be eligible for reimbursement, the qualified expense must have occurred within the plan year. 

Internal Revenue Code Section 125 and its regulations there under provide the tax guidance for FSAs.  Qualified health expenses are defined in IRC sections 79, 105(b) and 106.  The IRS has authorized the use of FSAs to reimburse employees for over-the-counter medications.  Pre-tax dollars can be used to purchase nonprescription medications as long as the transactions are adequately substantiated.  Qualified dependent care assistance programs and adoption assistance plans are defined in IRC sections 129 and 137, respectively.

Significance of Notice 2005-42

This notice allows employees to modify their FSAs by adopting a “grace period” which extends the deadline for reimbursements to up to two and a half months after the end of the plan year.  This extension, in effect, extends incurred qualified expenses to overlap into the first two and a half months of the next plan year.  Therefore, if an employee did not incur qualified expenses that equaled or exceeded the annual amount selected, the employee is afforded the additional time to incur qualified expenses subject to reimbursement from the FSA.

For example, suppose you have $200 left in your FSA as year-end approaches.  You plan to purchase new eyeglasses that cost $300.  Under the old rules, you would purchase the glasses in December, be reimbursed the $200 in your FSA and pay the $100 balance with your after tax dollars.

Thanks to the new rule, you can wait until January to purchase the eyeglasses and pay the full $300 cost with pretax FSA dollars.  The first $200 of the bill would come from last year’s unused $200; the remaining $100 would come from your 2006 FSA contributions.  If you put $1,000 in your flexible spending account, this would give you a $300 pair of new eyeglasses, paid for totally with pretax dollars and leave $900 in your FSA for reimbursement of qualified expenses for the remainder of the year.

Important Note:

Plan sponsors must amend their FSA plan documents before the end of the current plan year in order for this provision to be applicable.