November 20, 2012
Starting in 2013, the Patient Protection and Affordable Care Act imposes a $2,500 limit on employee contributions to health flexible spending accounts (health FSAs) sponsored by many employers as part of their group health plan offerings. Most employees have already received this news via their open enrollment materials.
In Notice 2012-40 (the Notice), the IRS provided guidance on various issues presented in administering the new limit. These issues are discussed below.
The new limit applies to plan years beginning on or after Jan. 1, 2013. Plans that operate on a fiscal-year basis do not have to adjust to the $2,500 limit prior to the end of their 2012-2013 plan year.
The $2,500 limit applies only to salary-reduction (pre-tax) contributions under a health FSA. The limit does not apply to employer “non-elective” contributions. Thus, for example, if the employer makes a $500 contribution of “flex dollars” to each employee’s FSAs, the employee may still make a maximum $2,500 salary-reduction contribution for that plan year.
The limit also does not apply to any of the following contributions:
- Employee pre-tax contributions used to pay premiums for the employer’s group health plan
- Contributions to a health savings account
- Contributions to a dependent care health flexible spending account
The $2,500 limit will be adjusted for inflation for plan years beginning after 2013. Increases to the annual limit will be adjusted in $50 increments; increases that are not a multiple of $50 will be rounded to the next lowest multiple of $50.
The new limit applies “per employee.” Each employee may elect up to $2,500 for an employer’s health FSA, but no more; there is no exception based on family size or income level. However, if the employee and the employee’s spouse are both eligible to participate in a health FSA, each may elect the full amount of $2,500. This applies even if the employee and spouse work for the same employer. The health FSA limit also applies on a controlled-group basis. Thus, for example, if an employee were eligible for a health FSA at two subsidiaries of one parent corporation, the employee would have a total limit of $2,500 for both plans. By contrast, an employee working for two non-related employers, both of whom sponsor plans with health FSAs, would be eligible to contribute $2,500 to each plan.
Adjustments to Plan Years
The IRS reminds plan sponsors in the Notice that plan years can be changed only for a valid business purpose. The Notice indicates that if the principal purpose of changing a plan year (calendar-to-fiscal or vice versa) is to delay implementation of the $2,500 limit, then the plan does not have a valid business purpose for the change. The effect is that the plan year for the cafeteria plan remains the plan year that was in effect prior to the change. This would result in an operational failure for the plan.
If the plan does have a valid reason for change, or if this is a newly-implemented plan, the plan could have a short plan year. In such a case, the $2,500 limit must be prorated.
Health FSA Grace Period
Many cafeteria plans provide for a grace period to allow participants access to unused amounts at year-end under the health FSA feature of the plan. The Notice provides that amounts that are carried over into the grace period do not count against the $2,500 limit on salary-reduction contributions available for the subsequent plan year. The grace period must otherwise comply with the IRS guidance relating to the implementation of the grace period under a cafeteria plan. The coordination with the grace period will also apply to plan years after 2013.
The IRS and the Treasury Department have announced that they are considering modifications to the “use-it-or-lose-it” rule, which generally prohibits leftover contributions from being used in a subsequent plan year. Currently, the only exception to this rule is the health FSA grace period. Comments were requested as part of Notice 2012-40. Possible modifications include imposing a limit on the amount at risk (for example, $500 or less of unused contributions). We will report any further developments in this area as they occur.
Correcting Errors in Applying New Limit
Employee contributions over the $2,500 limit will be considered a “non-qualified benefit” under the Internal Revenue Code Section 125 rules. Therefore, any excess contributions will be taxable income to the employee.
A cafeteria plan with a health FSA must be operated in compliance with the new limit or risk losing the tax-favored status for all participants. However, the Notice provides that if one or more employees are erroneously allowed to contribute more than the $2,500 (as indexed for inflation for years after 2013) in a plan year, the plan will still be considered a cafeteria plan for such year if the following conditions are satisfied:
- The terms of the plan document apply on a uniform basis to all employees;
- The error applies to a reasonable mistake by the employer (or by a service provider engaged by the employer) and the error is not due to willful neglect; and
- Employee contributions in excess of $2,500 are paid to the employee and reported as wages on the employee’s Form W-2.
This corrective relief is not available if a federal tax return of the employer is under examination by the IRS.
A cafeteria plan that includes a health FSA must be administered in accordance with the new $2,500 limit on employee contributions effective with the plan year beginning in 2013. A plan must also be amended to reflect the new limit, but the Notice allows such amendment to be adopted on or before Dec. 31, 2014.
Amendments can be adopted prior to this deadline and plan sponsors should consider including the $2,500 limit if other changes or updates are being made before the end of 2014. Even if plans will not be amended until 2013 or 2014, plan sponsors should take appropriate action through benefit plan committees or other decision makers to assure that the plan operates in accordance with the new limit. The cafeteria plan document should be reviewed to determine what action is required for an amendment to be made.
Plan Sponsor Checklist in Connection with $2,500 Limit
- Verify that employee communication materials and election forms are correct
- Ensure that the new limit has been properly authorized for plan operation, either through the plan administrator or appropriate benefits committee
- Schedule plan amendments to ensure that the amendments are adopted on or before Dec. 31, 2014
- During open enrollment, check election forms to verify that the $2,500 limit is not exceeded; correct errors before the plan year begins, if possible
- Coordinate with the payroll processor to assure that a “stop” is placed on an employee’s health FSA contributions once the $2,500 limit is reached during the plan year
For further information, contact either of the authors or any other member of the McGuireWoods employee benefits team.