IRS Guidance on $2,500 FSA Limit
This is part of our series of alerts intended to help guide employers and plan sponsors through their new obligations under the health care reform laws and related guidance. The IRS recently issued Notice 2012-40 (the “Notice”), which provides guidance on how the limit on contributions to health care flexible spending accounts (“FSAs”) applies. The health care reform laws require that the amount of salary reduction contributions to an FSA be limited to $2,500 (indexed for inflation) effective for “taxable years” beginning after December 31, 2012. Plan sponsors who have non-calendar year FSAs have been trying to determine how to apply these limits to their plan years ending in 2013, with little guidance.
The Notice provides that, for purposes of this $2,500 cap, “taxable years” means the FSA’s plan year. This means that the $2,500 limit will apply on a plan year basis, effective for plan years beginning after December 31, 2012. Thus, for non-calendar year plans, plan sponsors will not need to worry about the $2,500 cap until next year, and then they will need to apply the cap only to the plan year. For example, a FSA with a July 1 – June 30 plan year will not need to limit contributions to $2,500 until July 1, 2013. Note that the limit is indexed for inflation, and a plan sponsor is permitted to specify a limit lower than $2,500.
For calendar year FSAs, this guidance has little impact and the $2,500 limit will take effect on January 1, 2013.
The Notice also provides a grace period to amend FSAs to include the $2,500 limit – amendments must be adopted by December 31, 2014. However, the FSA must comply in operation with the limit and the Notice prior to the amendment.
The Notice also provides the following guidance:
- Plan Year Changes. An FSA’s plan year may be changed only if there is a valid business purpose. If the principal purpose of the change is to delay the application of the $2,500 limit, the change is invalid.
- Short Plan Year. If the FSA has a short plan year that begins after 2012, the $2,500 limit is prorated based on the number of months in the short plan year.
- Use-It-Or-Lose It. FSAs may still provide a grace period of up to two months and 15 days following the end of the plan year in which an employee must either use the amounts in the FSA for such plan year or lose it. The amounts that are carried over during the grace period do not count against the $2,500 limit for the next plan year. Thus, for the current plan year, if the FSA’s limit is greater than $2,500, the fact that there is a grace period in effect after the start of the next plan year will not result in a violation of the new rule. Note that the IRS is seeking comments on this rule, and it is unclear whether these comments will result in changes to the rule.
- Employee-by-Employee Basis. The limit applies on an employee-by-employee basis (rather than per household), which means that each spouse can contribute up to $2,500 to his or her FSA, even if they participate in the same FSA sponsored by the same employer.
- Salary Reduction Contributions Only. The $2,500 limit only applies to salary reduction contributions to an FSA. No limit applies to employer non-elective contributions such as flex credits, unless the employee can choose between receiving the flex credits as cash or a taxable benefit.
- Health Care FSAs Only. The limit does not apply to: (i) dependent care or adoption assistance FSAs, (ii) contributions used to pay an employee’s share of health coverage premiums (known as premium conversion salary reduction contributions), or (iii) contributions to health savings accounts (HSAs) or health reimbursement arrangements (HRAs).
- Excess Contributions. The Notice provides relief for excess contributions, as long as the employer’s tax return is not under examination for failure to comply with the limit. If the FSA timely complies with the written plan requirement limiting salary reduction contributions but an employee is mistakenly allowed to elect more than $2,500, the FSA will not lose its tax-favored status if: (i) the terms of the FSA apply uniformly to all participants, (ii) the error results from a reasonable mistake and not due to willful neglect by the employer, and (iii) contributions in excess of $2,500 are returned to the employee and reported as wages.