FSA Grace Period Ends, Unused Funds Disappear

March 12, 2007

Two months and 15 days – that's the magical number for Health FSA grace periods. Participants with FSA plan dollars remaining have a limited time to use the pre-tax dollars for medical expenses before the money disappears.

In 2005, the Treasury Department issued Notice 2005-42 which allows plan sponsors to design plans with up to an additional 2 1/2 month grace period, following the end of the plan year, to incur expenses before the use-it-or-lose-it rule would apply.

For calendar year FSA plans, the two months and 15 days for the grace period will end on March 15, then "poof" the money is gone (usually after a short run-out period). How can the money disappear without a magical trick? The wizards of Treasury have stated that any claims incurred following the grace period is forfeited by the participants. Thus, use-it-or-lose-it is simply delayed, not eliminated.

Many believe the ruling has brought increased participation in FSA plans. With the additional time, participants can now use monies left in FSAs and have it applied against the prior year's level of available benefits or contributions, until the end of the grace period. This gives many participants more ease in determining their FSA account balance for the year. If there is a balance at the end of the year, having additional time to use up the balance can make the decision to have an FSA easier and less stressful.

Notice 2005-86 states that a plan providing the grace period to participants covered on the last day of the plan year must include COBRA participants. Therefore, if a COBRA participant still has an active FSA plan on the last day of the plan year, that participant would also be offered the grace period.

Following this notice, informal guidance from the IRS provided further direction regarding the grace period and the effect on an FSA plan. According to the communication, an FSA would not lose its status as an excepted HIPAA benefit. The FSA would not be subject to the full 18-, 29- or 36-month COBRA period but would be limited to the COBRA continuation period, which is the remainder of the plan year. Therefore, the COBRA participant's coverage would not extend beyond the grace period and would end when the grace period concludes.

Recently-passed legislation has offered added direction to the grace period. Prior to this law, an FSA could cause problems for participants wanting to add a Health Spending Account (HSA). Previously, an individual could not fund an HSA while still having an FSA plan in existence. On December 20, 2006, President Bush signed the Tax Relief and Health Care Act of 2006, H.R. 6111, (TRHCA) which allows HSA participation to begin either when the participant has a zero balance at the end of the plan year or by allowing the participant to rollover the remaining FSA balance to an HSA if the FSA has a grace period.

For the participant to rollover the FSA balance into the HSA, certain requirements must be met. The rollover amount must be no more than the lesser of the FSA balance on September 21, 2006, or at the time of distribution. The transfer must be directly from the employer to the HSA and take place no later than December 31, 2011. The rollover can only occur once from that particular account.

Furthermore, to remain exempt from any taxation and an additional 10 percent tax, the rollover must satisfy these conditions:

• By the plan year end:
• The FSA or HRA must be amended
• The employee must elect the rollover
• The year-end balance must be frozen
• The fund must be transferred by the employer within 2 1/2 months after the end of the plan year and must result in a zero balance in the FSA
• The individual must continue to have high-deductible health plan (HDHP) coverage for a testing period of an additional 12 months after the month in which the rollover is made.

The TRHCA was followed by an IRS posting of Notice 2007-22 on February 15, 2007, which provided additional clarification and transitional relief for rollover from FSAs to HSAs. This notice provided special transitional relief in two manners until March 15, 2007:

• There is no requirement to freeze the year-end balance in the FSA
• The plan amendment, election and transfer requirements are extended until then, instead of the end of the plan year.

The magical part of is that for general purpose FSAs, eligibility for this rollover provision requires a grace period. If the distribution was made on the last day of the plan year, the individual would not be eligible because of the disqualifying non-HDHP coverage. If the distribution was on the first day of the plan year, there is no balance because of the use-it-or-lose-it rule. Therefore, the rollover from an FSA to an HSA is contingent on a grace period being in place for the FSA; otherwise, the distribution is taxable and subject to an additional 10percent penalty. (For more detailed information on this notice, please see the News & Review article released February 16, 2007: www.benefitsolved.com/news/stories/new_review20070216-1.asp).

Applying the grace period ruling is optional and employer/plan sponsors must notify participants prior to the end of the plan year with an amendment regarding the additional grace period. The additional time needs to be offered to all participants. This applies only to Health FSAs, not dependent care FSAs.

In addition, the grace period can be shorter than the 2 1/2 months but not longer. There are no restrictions preventing a limit on the carryover amount for the grace period. A run out period following the grace period may be allowed, which provides participants time to submit expenses from the grace period but turn them in during the run out period.

An FSA is an IRS-approved, tax exempt account that saves participants' money on eligible medical 213(d) expenses. The money is deposited each pay period into participants' FSA and is deducted from gross pay before taxes are calculated. FSA funds are exempt from both federal income and Social Security and Medicare taxes. As eligible expenses occur, participants withdraw funds from the FSA account for reimbursement.

One of the greatest advantages of an FSA is the tax savings generated and the increase in spendable income for participants. However, it's not just the employees who save. By reducing payroll with pre-tax deductions, the employer can also realize a significant tax savings. The additional grace period for the participants and recent legislation for HSA plans make these plans more advantageous for everyone. For more information on how Infinisource can assist you with FSA and/or HSA administration, please contact us at 800-779-6384 or at solutions@infinisource.net.