Cashout Feature Would Replace “Use it or Lose It” Rule for Medical FSAs

U.S. Representatives Charles Boustany (R. Louisiana) and John Larson (D. Conn.) have proposed a bill, the Medical Flexible Spending Account Improvement Act (H.R. 1004), that would repeal the “use it or lose it rule” applicable to medical flexible spending accounts or “FSAs” effective January 1, 2013. A prior version of this bill was introduced in 2009, also with bipartisan support, but appears to have died in committee.

The use it or lose it rule is the most often-cited reason that employees choose not to enroll in medical FSAs, which often form part of a cafeteria or “flex” plan under Section 125 of the Internal Revenue Code. The rule exists because Section 125 plans are barred from operating as a means of deferring income from one year to the next. Employees who overestimate their reimbursable expenses must leave unused, deferred cash compensation in their employers flex accounts unless they can come up with last-minute reimbursable expenses, such as new eyeglasses.

The Act would allow employees to take their unused health FSA balance as a taxable distribution after the close of the plan year to which the balance relates, and no later than the end of the 7th month following the plan year end. Thus, an employee who participates in a medical FSA with a calendar plan year would be able to receive distribution of their unused 2013 account balance on or after January 1, 2014, but no later than July 31, 2014. The distributed amount would be included in the employee’s taxable income for 2014.

The bill contains a transition rule applicable for plan years that begin before the date the bill is enacted, allowing individuals to make a new medical FSA election or revise an existing one so long as the new election is made within 90 days after the date of enactment of the bill.

Medical FSAs are subject to other changes under PPACA; this year the ability to receive reimbursement of over-the-counter medicines ended, unless a doctor’s note for the OTC item is provided. And in 2013 the maximum reimbursement amount – currently without a ceiling – is capped at $2,500.

Eliminating forfeitures under health FSAs will expose employers to more out of pocket expenses in operating these arrangements. Employers must act as insurers under these plans, making 100% of the reimbursement budget available to each employee on day 1 of the plan year, and can get burned by employees who cash out and quit early in the calendar year. Forfeiture accounts will no longer be available to make up for such losses. However employers’ exposure also will be capped by the $2,500 dollar limit, and if elimination of the use it or lose it rule increases medical FSA participation, they will enjoy a reduced employment tax burden.