Under the Health Care Reform Act, health flexible spending arrangements under cafeteria plans are limited to $2,500 in salary reduction contributions beginning in 2013. Employers with plan years that were not calendar years have been wondering how the limit would be applied. The IRS has now issued guidance in the form of Notice 2012-40 with answers that are generally sensible and employer friendly. Specifically:

The $2,500 limit will apply based on plan years and will not apply until plan years that begin in 2013.

A plan that provides a “grace period” (the period of up to 2½ months after the close of the plan year in which to incur claims to be paid from the prior year’s election) does not need to take into account amounts that are carried over into the grace period in applying the $2,500 limit. So an employee who carries over $100 to use during the grace period, for example, can still also contribute to the FSA $2,500 for the plan year that overlaps the grace period.

Plans must be amended to reflect the $2,500 limit but that amendment can be made at any time through the end of calendar year 2014.

Employers who make errors in the salary reduction contribution so that the $2,500 is exceeded can correct the error by repaying the excess to the participant by the end of the participant’s taxable year (typically the calendar year) within which or in which the cafeteria plan year ends.

The $2,500 limit applies only to salary reduction contributions. It does not apply to flex credits that an employer might provide under the plan or to HSAs or HRAs. However, flex credits available to a participant either in cash or as benefits are treated as salary reduction contributions.

In a surprise move, the IRS has also asked for comments on whether the cafeteria plan rules should be amended to modify the “use it or lose it” rule. Under that rule, added by the IRS in its proposed regulations, contributions that are not used by the end of the plan year (or grace period if the employer offers a grace period under its plan) are lost to the employee. Because the new $2,500 statutory limit on contributions will reduce amounts that an employee could defer from year to year, the IRS is willing to consider modification of the use it or lose it rule. The IRS has requested comments on that possibility.  

Employers whose cafeteria plans have not yet been amended for this new limit should contact their service providers about preparing appropriate amendments.