The Internal Revenue Service recently published Notice 2012-40 in which it provided guidance with regard to the $2,500 limitation effective next year for health flexible spending arrangements (Health FSAs) subject to Internal Revenue Code (Code) Section 125. The reduction in the maximum amount of contribution (from the current limit of $5,000) was enacted as part of the Patient Protection and Affordable Care Act. Health FSAs with a cap on employee contributions which exceed $2,500 will have to be amended to come into line with this new limitation.

The key points contained in Notice 2012-40 are as follows:

  • The $2,500 limit does not apply for plan years that begin before 2013.  
  • Plans may adopt the required amendment to reflect the new limit at any time before January 1, 2015 (despite the rule that generally prohibits retroactive amendments to FSAs), provided that the cafeteria plan operates in accordance with the limitation for plan years beginning after 2012.  
  • In the case of a plan providing a grace period (which may be up to two months and 15 days), unused contributions for plan years beginning in 2012 or later that are carried over into the grace period will not count against the $2,500 limit for the subsequent plan year.  
  • Salary reduction contributions exceeding the $2,500 limit that are due to a reasonable mistake of fact and not willful neglect and that are corrected by the employer in a timely manner (including reporting them as wages for income tax withholding and employment tax purposes on Form W-2) will continue to qualify as a cafeteria plan under Code Section 125.

Additional Points of Interest

Note that the new $2,500 limitation applies only to salary reduction contributions to a Health FSA and does not apply to certain employer non-elective contributions (sometimes called flex credits), to any types of contributions or amounts available for reimbursement under other types of FSAs, health savings accounts, health reimbursement arrangements, or to salary reduction contributions to cafeteria plans that are used to pay an employee's share of health coverage premiums for an insured or self-insured health plan.

The $2,500 limitation will be indexed for cost-of-living adjustments for plan years beginning after 2013.

The Treasury Department and IRS also intend to amend the regulations under Code Section 125 to provide for the new $2,500 limitation. Notice 2012-40 provides that until such amended regulations are issued, taxpayers may rely on the guidance in Notice 2012-40.

The Notice also requests comments regarding potential modifications to the "use-it-or-lose-it rule." The IRS and Treasury Department are considering enacting an additional form of flexibility (instead of or in addition to the two-and-a-half month grace period rule) with respect to the use-it-or-lose-it rule, and have solicited comments by August 17.

For a copy of IRS Notice 2012-40, click here.