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    Did the IRS recently liberalize the "use-it-or-lose-it" rule?

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    Question: Did the IRS recently liberalize the "use-it-or-lose-it" rule?

    Answer: Yes, with Notice 2005-42, the IRS now permits employers with cafeteria plans to adopt a grace period within which participants may use funds in their flexible spending account ("FSA") to pay claims incurred during such grace period.  The grace period cannot exceed 2 and 1/2 months following the end of the plan year. 

    As background, an FSA is a benefit offered through a cafeteria plan (a.k.a, a "125 plan") for the purpose of paying/reimbursing eligible expenses on a pre-tax basis (such eligible expenses include medical, dental, vision and dependent care).  The FSA is typically funded by the participant using his or her own pre-tax dollars.  In such instances, the participant sets the funding amount according to his or her estimated eligible expenses that will be incurred during the plan year.  However, the participant needs to be wary because, prior to Notice 2005-42, any FSA amounts not used for eligible expenses incurred during the plan year are forfeited to the employer (they cannot be used to pay/reimburse eligible expenses incurred outside of the plan year for which they are contributed).  This is known as the "use-it-or-lose-it" rule.

    With Notice 2005-42, the use-it-or-lose-it rule remains in effect, however, its harshness is somewhat alleviated by allowing employers to extend the date within which eligible expenses must be incurred.  Under Notice 2005-42, an FSA may reimburse any expense incurred during the plan year and up to the 15th day of the third month following the end of the plan year (i.e., March 15th for calendar year plans).  This new rule contrasts with prior law that limited reimbursements to only those eligible expenses incurred during the plan year

    In order to implement the 2 and 1/2 month grace period afforded by Notice 2005-42, the employer needs to amend its plan document and apply the grace period in a nondiscriminatory manner.  If adopted, any amounts remaining in an FSA after the grace period are still subject to the use-it-or-lose-it rule and are forfeited to the employer.


    Anthony J. Eppert  is a benefits and compensation attorney in Luce Forward, Hamilton & Scripps LLP´s San Diego office.  He can be reached at (619) 699-2506 or aeppert@luce.com.  Founded in 1873, Luce Forward is a full service law firm serving all of California with offices in San Diego, Carmel Valley/Del Mar, Los Angeles, and San Francisco.

     

     



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