3
employees of predicting their future needs for medical expenditures, the desirability of
minimizing incentives for unnecessary spending at the end of a year or grace period, the
possibility that lower- and moderate-paid employees are more reluctant than others to
participate because of aversion to even modest forfeitures of their salary reduction
contributions, and the opportunity to ease and potentially to simplify the administration of
health FSAs. In light of these comments, the Treasury Department and the IRS have
determined that it is appropriate to modify the use-or-lose rule to permit the use of up to
$500 of unused amounts in a health FSA in the immediately following plan year.
Accordingly, an employer, at its option, is permitted to amend its § 125 cafeteria
plan document to provide for the carryover to the immediately following plan year of up to
$500 of any amount remaining unused as of the end of the plan year in a health FSA.
The carryover of up to $500 may be used to pay or reimburse medical expenses under
the health FSA incurred during the entire plan year to which it is carried over. For this
purpose, the amount remaining unused as of the end of the plan year is the amount
unused after medical expenses have been reimbursed at the end of the plan’s run-out
period
3
for the plan year. In addition to the unused amounts of up to $500 that a plan
may permit an individual to carry over to the next year, the plan may permit the individual
to also elect up to the maximum allowed salary reduction amount under § 125(i). Thus,
the carryover of up to $500 does not count against or otherwise affect the indexed
$2,500 salary reduction limit applicable to each plan year. Although the maximum
unused amount allowed to be carried over in any plan year is $500, the plan may specify
a lower amount as the permissible maximum (and the plan sponsor has the option of not
permitting any carryover at all).
A plan adopting this carryover provision is not permitted to also provide a grace
period with respect to health FSAs. Nor is the plan, for any plan year, permitted to allow
an individual to salary reduce for qualified health FSA benefits more than the indexed
$2,500 salary reduction limit or permitted to reimburse claims incurred during the plan
year that exceed the applicable indexed $2,500 salary reduction limit (and any
nonelective employer flex credits) plus the carryover amount of up to $500. If an
employer amends its plan to adopt a carryover, the same carryover limit must apply to all
plan participants. A § 125 cafeteria plan is not permitted to allow unused amounts
relating to a health FSA to be cashed out or converted to any other taxable or nontaxable
benefit. Unused amounts relating to a health FSA may be used only to pay or reimburse
certain § 213(d) medical expenses (excluding health insurance, long-term care services
3
A “run-out period” is a period immediately following the end of a plan year during which a participant can
submit a claim for reimbursement of expenses incurred for qualified benefits during the plan year. See Prop. Treas.
Reg. § 1.125-1(f). By contrast, a grace period is a period of up to two months and 15 days immediately following the
end of a plan year during which a participant may use amounts remaining from the previous plan year (including
amounts remaining in a health FSA) to pay expenses incurred for certain qualified benefits during that two-month-
and-15-day period. See Notice 2005-42, 2005-1 C.B. 1204, and Prop. Treas. Reg. § 1.125-1(e). (A run-out period
may also be provided immediately following the end of a grace period instead of immediately following the end of a
plan year, so that participants can submit claims for reimbursement of expenses incurred during the grace period or
the previous plan year.)