**Question: **What are the rules surrounding the Section 125 cafeteria plan offering a $550 carryover and/or grace period under the health FSA and dependent care FSA?

**Short Answer_: _**The health FSA can offer the $550 carryover or the grace period (but not both), and the dependent care FSA can offer only the grace period.

**New Rule: **IRS Indexes Carryover Limit to $550 (20% of the Health FSA Salary Reduction Limit)

The IRS has permitted health FSAs to offer a carryover provision of up to $500 since 2013.

The IRS recently in Notice 2020-33 increased the carryover limit for 2020 and later plan years to 20% of the maximum health FSA salary reduction contribution for that plan year. The indexed limit will be in multiples of $10.

For plan years beginning on or after January 1, 2020, the health FSA salary reduction limit is $2,750. Accordingly, the health FSA maximum carryover for a plan year starting in the calendar year 2020 to a new plan year starting in the calendar year 2021 is $550.

For full details on these new rules, see our Compliance Alert: IRS Increases Health FSA Carryover Limit to $550.

**$550 Carryover: **Health FSA Only

The $550 carryover is an optional plan feature available for the health FSA only. Dependent care FSAs cannot offer a carryover.

This feature permits health FSA participants to carry over up to $550 (2020 maximum) of unused amounts the subsequent plan year. A health FSA offering the carryover cannot also offer the grace period.

Example:

• Elena elects to contribute $2,750 to the health FSA for her employer’s 2020 calendar plan year.

• The health FSA offers the $550 carryover.

• Elena has claimed $2,000 of the health FSA balance as of the end of the 2020 plan year.

Result:

• Elena has $750 unused amounts remaining in the 2020 health FSA after the end of the plan year.

• Elena will carry over $550 of her unused amounts to the 2021 plan year.

• Elena forfeits the remaining $200 in unused amounts that are in excess of $550.

The carryover is an optional plan feature not offered by all health FSAs. The cafeteria plan document must incorporate the carryover feature for it to be available under the health FSA.

• **Advantage of the $550 Carryover: **Amounts carried over are available for reimbursement beyond the first 2 months of the subsequent plan year.

• **Disadvantage of the $550 Carryover: **Participants cannot carry over more than $550 (2020 maximum) into a subsequent plan year.

On net, most employers feel that the $550 carryover is a better overall plan feature for health FSA participants than the grace period.

**Grace Period: **Health FSA and/or Dependent Care FSA

The grace period is an optional plan feature available for the health FSA and/or the dependent care FSA.

This feature permits FSA participants with unused amounts at the end of the plan year to continue incurring reimbursable claims from that unused balance for 2 months following the end of the plan year. The effect of the grace period is that participants have 14 months and 15 days (the 12-month plan year plus the 2 month grace period) to claim their FSA balance before those amounts forfeit under the Section 125 use-it-or-lose-it rule.

Following the expiration of 2 -month the grace period, the plan may provide for a run-out period (e.g., 90 days) for participants to submit claims that were incurred no later than the end of the run-out period.

Example:

• Natasha elects to contribute $2,750 to the health FSA for her employers 2020 calendar plan year.

• The health FSA offers the 2 -month grace period.

• Natasha has claimed $2,000 of the health FSA balance as of the end of the 2020 plan year.

Result:

• Natasha has $750 unused amounts remaining in the 2020 health FSA after the end of the plan year.

• Natasha can continue incurring up to $750 in qualifying medical expenses from January 1, 2021 through March 15, 2021 (the 2 -month graced period) that are reimbursable from her 2020 plan year balance.

• Natasha will forfeit any unused amounts remaining at the end of the grace period (and any associated run-out period).

The grace period is an optional plan feature not offered by all FSAs. The cafeteria plan document must incorporate the grace period feature for it to be available under the health FSA and/or dependent care FSA.

• **Advantage of the Grace Period: **There is no cap on the amount available to participants during the grace period.

• **Disadvantage of the Grace Period: **Participants cannot access unused amounts beyond the first 2 months of the subsequent plan year.

On net, most employers feel that the $550 carryover is a better overall plan feature for health FSA participants than the grace period. However, because the $550 carryover is available only for the health FSA, many employers still offer the grace period for the dependent care FSA. Cafeteria plans are permitted to (and often do) offer the carryover for the health FSA, and the grace period for the dependent care FSA.

**Required Cafeteria Plan Amendments: **Adding the $550 Carryover or the Grace Period

Amendments to the cafeteria plan to add the $550 carryover or grace period must be adopted no later than the end of the plan year in which the feature is added (i.e., by the end of the original plan year, not the grace period or carried over plan year).

The general carryover amendment rule is that employers can amend the cafeteria plan by the last day of the plan year from which amounts can be carried over to:

1. Add the carryover provision, or

2. Increase an existing $500 carryover to follow the indexed carryover limit ($550 in 2020).

A special rule for the 2020 plan year only permits employers to amend the cafeteria plan no later than December 31, 2021 to change an existing $500 carryover provision to the $550 increased indexed limit for amounts carried over from the 2020 plan year to the 2021 plan year. This special 2020 plan year extended timeframe applies in place of the standard rule that would otherwise require the amendment by the last day of the 2020 plan year, and it is available as long as the employer informs all eligible employees of the plan changes.

**Important Note for Health FSAs Moving from the Grace Period to the Carryover: **Employers generally should not amend a plan that offers the grace period mid-year to convert to the carryover for the current plan year. Employees may have made their elections intending to utilize their health FSA balance during the grace period by combining a year-one and year-two election for a high-cost procedure (e.g., laser eye surgery). IRS guidance suggests that this approach may be subject to non-Code legal restraints, such as an ERISA breach of fiduciary duty claim. Any such amendment to move from the grace period to the carryover should be made in a manner that ensures employees are aware of the change when making their health FSA elections at open enrollment.

**Additional Considerations: **$550 Carryover and Grace Period

• The $550 carryover and grace period for a general purpose health FSA can affect HSA eligibility. Full details here: https://www.newfront.com/blog/health-fsa-carryover-grace-period-affect-hsa-eligibility-2

• The $550 carryover availability can be conditioned on the employee making a new election to participate in the health FSA for the subsequent plan year. Full details here: https://www.newfront.com/blog/health-fsa-500-carryover-conditioned-on-new-plan-year-election-2

Regulations

IRS Notice 2020-33:

https://www.irs.gov/pub/irs-drop/n-20-33.pdf

Specifically, this notice increases the maximum $500 carryover amount for a plan year to an amount equal to 20 percent of the maximum salary reduction contribution under 125(i) for that plan year. Because, by statute, the increase to the 125(i) limit is rounded to the next lowest multiple of $50, increases to the maximum carryover amount, as the result of that indexing, will be in multiples of $10 (20 percent of any $50 increase to the 125(i) limit). Thus, the maximum unused amount from a plan year starting in 2020 allowed to be carried over to the immediately following plan year beginning in 2021 is $550 (20 percent of $2,750, the indexed 2020 limit under 125(i)).

Accordingly, a plan may be amended to adopt the increased carryover amount for a plan year that begins in 2021, for example, at any time on or before the last day of the plan year that begins in 2021; see section III.C. for a special amendment timing rule for the 2020 plan year.

With respect to the requirement to amend the written plan, Notice 2020-29 provides that an amendment under this notice for the 2020 plan year must be adopted on or before December 31, 2021, and may be effective retroactively to January 1, 2020, provided that the employer informs all individuals eligible to participate in the 125 cafeteria plan of the changes to the plan.

IRS Notice 2013-71:

https://www.irs.gov/pub/irs-drop/n-13-71.pdf

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 plans run-out period3 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.

To utilize the new carryover option permitted under this notice, a 125 cafeteria plan offering a health FSA must be amended to set forth the carryover provision. The amendment must be adopted on or before the last day of the plan year from which amounts may be carried over and may be effective retroactively to the first day of that plan year, provided that the 125 cafeteria plan operates in accordance with the guidance under this notice and informs participants of the carryover provision. A 125 cafeteria plan that incorporates a carryover provision may not also provide for a grace period in the plan year to which unused amounts may be carried over if a plan has provided for a grace period and is being amended to add a carryover provision, the plan must also be amended to eliminate the grace period provision by no later than the end of the plan year from which amounts may be carried over. The ability to eliminate a grace period provision previously adopted for the plan year in which the amendment is adopted may be subject to non-Code legal constraints.

IRS Notice 2005-42:

https://www.irs.gov/pub/irs-drop/n-05-42.pdf

A cafeteria plan document may, at the employers option, be amended to provide for a grace period immediately following the end of each plan year. The grace period must apply to all participants in the cafeteria plan. Expenses for qualified benefits incurred during the grace period may be paid or reimbursed from benefits or contributions remaining unused at the end of the immediately preceding plan year. The grace period must not extend beyond the fifteenth day of the third calendar month after the end of the immediately preceding plan year to which it relates (i.e., the 2 and 1/2 month rule). If a cafeteria plan document is amended to include a grace period, a participant who has unused benefits or contributions relating to a particular qualified benefit from the immediately preceding plan year, and who incurs expenses for that same qualified benefit during the grace period, may be paid or reimbursed for those expenses from the unused benefits or contributions as if the expenses had been incurred in the immediately preceding plan year. The effect of the grace period is that the participant may have as long as 14 months and 15 days (the 12 months in the current cafeteria plan year plus the grace period) to use the benefits or contributions for a plan year before those amounts are forfeited under the use-it-or-lose-it rule.

An employer may adopt a grace period as authorized in this notice for the current cafeteria plan year (and subsequent cafeteria plan years) by amending the cafeteria plan document before the end of the current plan year.

Prop. Treas. Reg. 1.125-1(e)(1):

(e) Grace period.

_(1) In general. _A cafeteria plan may, at the employer’s option, include a grace period of up to the fifteenth day of the third month immediately following the end of each plan year. If a cafeteria plan provides for a grace period, an employee who has unused benefits or contributions relating to a qualified benefit (for example, health flexible spending arrangement (health FSA) or dependent care assistance) from the immediately preceding plan year, and who incurs expenses for that same qualified benefit during the grace period, may be paid or reimbursed for those expenses from the unused benefits or contributions as if the expenses had been incurred in the immediately preceding plan year. A grace period is available for all qualified benefits described in paragraph (a)(3) of this section, except that the grace period does not apply to paid time off and elective contributions under a section 401(k) plan. The effect of the grace period is that the employee may have as long as 14 months and 15 days (that is, the 12 months in the current cafeteria plan year plus the grace period) to use the benefits or contributions for a plan year before those amounts are forfeited under the use-or-lose rule in paragraph (c) in 1.125-5. If the grace period is added to a cafeteria plan through an amendment, all requirements in paragraph (c) of this section must be satisfied.

Newfront: Section 125 Cafeteria Plans