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Implementation of New Health Flexible Spending Account Limits

One of the first revisions to an employer’s health care program mandated by Health Care Reform is the new limit on salary reduction contributions to Health Flexible Spending Accounts (FSAs).

Existing Law

Before Health Care Reform, there was no statutory or regulatory limit on how much an employer could allow an employee to elect to contribute on a pre-tax basis to an FSA.

As a practical matter, employers limited how much an employee could contribute to an FSA to control an employer’s exposure to claims under the immediate availability requirement that the entire FSA amount be available as of the beginning of the plan year, which could result in an employee who terminates employment during the year receiving more in reimbursements from his or her FSA than the contributions actually deducted from the employee’s compensation up to the date of termination.

New Law

Effective for FSA plan years beginning after December 31, 2012, an employee’s contributions to an FSA are statutorily limited to $2,500 per year. For calendar year plans, which include the majority of FSA plans, the most an employee can elect to contribute to the FSA for 2013 is $2,500. The $2,500 limit will be indexed for inflation beginning in 2014, in multiples of $50.

Note that the $2,500 limit includes any employer contributions (such as flex credits) that an employee can elect to receive in cash, contribute to a Code Section 401(k) plan, or use to purchase taxable benefits (for purposes of this discussion, “nonqualifying employer contributions”). If the employee can only apply the employer contributions to purchase non-taxable benefits, such as group health plan premiums or FSA contributions, and any unused employer contributions are forfeited (for purposes of this discussion, “qualifying employer contributions”), the employer contributions are not included in the $2,500 limit.

The $2,500 annual limit is not reduced or otherwise affected if the FSA plan has a “grace period” under which unused FSA amounts are available to reimburse eligible expenses incurred during the “grace period” occurring after the end of the FSA plan year. Any unused FSA amounts relating to employee contributions from one plan year available during the “grace period” at the beginning of the next FSA plan year do not count against the employee’s $2,500 employee contribution limit for the next FSA plan year.

Also, the $2,500 limit applies on an employee-by-employee basis with respect to each FSA plan. This means that married employees who both participate in the same employer’s FSA plan may each contribute $2,500 to that FSA plan. Similarly, an individual who participates in more than one FSA plan sponsored by unrelated employers may contribute $2,500 to each FSA plan.

Planning Considerations

As noted above, qualifying employer contributions are not subject to the $2,500 limit. An employer can therefore elect to provide qualifying employer contributions to an employee’s FSA in excess of the $2,500 limit. For example, an employer could provide $1,000 in qualifying employer contributions (as either matching or non-matching employer contributions) and also permit an employee to elect to contribute an additional $2,500 to the FSA from the employee’s compensation. Note, however, that all qualifying employer contributions to an employee’s FSA are also subject to immediate availability requirements, which increases the employer’s risk exposure for employees who “overspend” their FSAs early in the year and terminate employment during the year. In the above example, the employer would be required to provide $3,500 of reimbursements beginning on the first day of the plan year, even though the employee has not yet contributed any of the $2,500 in employee contributions. If the employee requests the full $3,500 in reimbursements by the end of the third month of the year, and then terminates employment in the fourth month of the year, the employer cannot recover any of the $3,500 in reimbursements in excess of the amount already withheld from the employee’s compensation through the date of termination.

Action Steps

If the employer has not already done so, it should determine what limit it will impose on employee contributions to its FSA plan for 2013, whether the employer will make qualifying or nonqualifying employer contributions to the FSA plan for 2013, and whether any qualifying employer contributions will be matching contributions or non-matching contributions. Employers will need to inform employees of the employee contribution limit and any qualifying or nonqualifying employer contributions to be made for the year during the FSA plan open enrollment period for 2013.

Employers who decide to make employer contributions to the FSA plan, and whose FSA plan documents do not currently provide for employer contributions, will need to amend their FSA plan documents. Similarly, employers who currently provide nonqualifying employer contributions and who want to exclude those employer contributions from the $2,500 limit must amend their FSA plan documents so that the employer contributions are qualifying employer contributions. Note that these amendments must be adopted before the first day of the 2013 plan year.

Employers also need to amend their FSA plan to reflect the $2,500 limit. The Internal Revenue Service permits this amendment to be adopted retroactively, as long as the FSA plan operationally applies the $2,500 limit beginning with the first FSA plan year beginning after December 31, 2012 and the amendment is adopted by December 31, 2014.

Note also that the Internal Revenue Service has solicited comments on whether the “use it or lose it” rule should continue to apply to FSAs now that the amount of employee contributions has been statutorily limited. The IRS has not yet issued any guidance or rulings in this area yet, but is expected to do so in the near future.

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