Flexible spending accounts temporarily are more flexible

| 2/25/2021
Flexible spending accounts temporarily are more flexible

The Taxpayer Certainty and Disaster Relief Act of 2020 (the act) included in the Consolidated Appropriations Act, 2021, which was enacted on Dec. 27, 2020, includes temporary relief in connection with health and dependent care flexible spending arrangements (FSAs) under cafeteria plans. The U.S. Department of the Treasury and the IRS recently released Notice 2021-15 to provide much needed guidance on the act’s temporary relief.

Section 125 cafeteria plans and FSAs

Generally, an IRC Section 125 cafeteria plan must satisfy numerous requirements. Among these are that the plan must be in writing, be limited to employees, satisfy nondiscrimination requirements, and permit participants to choose among two or more benefits consisting of cash and “qualified benefits” (certain benefits that otherwise are not includible in an employee’s wages under another tax code provision). Qualified benefits include (but aren’t limited to) FSAs for qualified medical expenses (health FSAs) and FSAs under an IRC Section 129 dependent care assistance program (dependent care FSA).

Generally, the employee must elect before the first day of a plan year to reduce salary so that dollars can be available for reimbursement of qualified benefit expenses incurred during the plan year. The election to reduce salary is irrevocable unless the plan includes the ability to revoke or change the election for permitted midyear changes.

The annual limit on an employee’s salary reduction for a health FSA is $2,750 (for 2020 and 2021). This limit is $5,000 (for 2020 and 2021) for a dependent care FSA. If applicable rules are satisfied for the qualified benefit and the cafeteria plan, both the salary reductions and reimbursements are not taxable wages to the employee.

For both a health FSA and a dependent care FSA, the general cafeteria plan rules require the employee to forfeit amounts remaining in the FSA at the end of a plan year (the “use-it-or-lose-it” rule). However, a plan may permit a grace period of up to 2 1/2 months immediately after the end of the plan year for employees to use those amounts.

For a health FSA, instead of a grace period, an employer may instead allow a limited amount of unused funds in a plan year to be carried forward to the next plan year (the “carryover” rule), but these carryover amounts must be forfeited if not used by the end of the subsequent plan year. The carryover limit for 2020 was $500 in 2020 and is $550 in 2021.

Last year, among other relief, Treasury and the IRS extended the period during which employees could apply unused health FSA amounts and dependent care FSA remaining as of the end of a grace period or plan year ending in 2020 to pay or reimburse medical care expenses or dependent care expenses incurred through Dec. 31, 2020.

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Relief under the act

Under the act, and as clarified in Notice 2021-15, an employer sponsoring a cafeteria plan that includes a health FSA or dependent care FSA may temporarily amend the plan to:

  • Permit carryover (under rules similar to health FSA carryover rules) of unused benefits or contributions remaining in a health FSA, or remaining in a dependent care FSA, from a plan year ending in 2020 to the plan year ending in 2021, and from a plan year ending in 2021 to the plan year ending in 2022
  • Extend a grace period in place for a plan that includes a health FSA or dependent care FSA to 12 months after the end of the plan year, for a plan year ending in 2020 or 2021
  • Permit a former employee who participated in a plan that includes a health FSA and who ceased participation during 2020 or 2021 to continue to receive reimbursements from unused benefits or contributions through the end of the plan year in which the employee ceased participation (including any grace period, as extended)
  • Permit reimbursement to an employee enrolled in a dependent care FSA for a plan year for which the regular enrollment period ended before Feb. 1, 2020, for claims for eligible expenses until the end of the plan year related to a dependent who attains age 13 during the plan year, or until the dependent attains age 14 if the plan has adopted the carryover rule for such claims in the subsequent plan year, limited to the employee’s unused balance on the last day of the plan year
  • Permit prospective midyear changes in salary reduction elections with respect to FSAs without regard to any change in the employee’s status for a plan year ending in 2021

Notice 2021-15 also includes relief on the effective date of cafeteria plan amendments relating to the expansion of permitted health FSA and health reimbursement arrangement expenses to include over-the-counter drugs without prescriptions and menstrual care products under the Coronavirus Aid, Relief, and Economic Security Act.

Next steps

If an employer adopts a cafeteria plan amendment relating to any of the act’s FSA relief provisions by Dec. 31 of the first calendar year that begins after the end of the plan year in which the amendment becomes effective, the employer can implement such relief before the amendment is adopted as long as it operates the cafeteria plan and related FSA consistent with the terms of the amendment. Employers electing to implement the temporary relief should communicate the changes to employees and coordinate with administrators.

The rules relating to these plans and arrangements are complex. Employers should consider obtaining advice from appropriate advisers to understand how the temporary relief applies to their specific plan and arrangement to verify tax and other compliance.

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Veena Murthy
Veena Murthy
Principal, Washington National Tax