Now that the Supreme Court has upheld the constitutionality of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act (collectively, the “Act”), employers must move forward with implementation. This series of newsletter articles focuses on the changes that most immediately affect employer group health plans and may require immediate attention, especially for employers who have taken a wait-and-see approach in hopes that the Act would be invalidated.

This alert, the fourth in the series, discusses the Act’s new $2,500 cap on salary reduction contributions to health flexible spending accounts (health FSAs).

On May 30, 2012, the Internal Revenue Service (IRS) released Notice 2012-40 providing guidance regarding the $2,500 cap on salary reduction contributions to health FSAs. The new cap is established by the Act through the addition of Internal Revenue Code (Code) Section 125(i).


A cafeteria plan, if it meets certain requirements under Code Section 125, allows employees to reduce their taxable salary by electing to contribute a certain amount to a health FSA. Although employers often impose their own limit on the amount an employee may contribute to a health FSA, the Code had imposed no such limit prior to the Act. Notice 2012-40 (the Notice) clarifies several aspects of the new $2,500 annual cap on contributions to health FSAs.

The Notice provides the following guidance:

  • Effective Date: Although Code Section 125(i) uses the term taxable year, the Notice clarifies that the $2,500 cap must be imposed for plan years beginning on or after January 1, 2013.
  • Amendments: Cafeteria plans must normally be amended in advance of the effective date of a change. Plans that currently have a health FSA limit in excess of $2,500 will have to be amended to reflect the $2,500 limit. The Notice provides that plans may adopt retroactive amendments to reflect the $2,500 cap at any time before December 31, 2014, provided that the plan operates in accordance with the $2,500 limit for plan years beginning on or after January 1, 2013.
  • Limited Scope: The $2,500 annual cap is limited to health FSAs. It does not apply to the following arrangements:
    • Contributions to an FSA for dependent care assistance or adoption care assistance;
    • Contributions used to pay an employee’s share of health coverage premiums;
    • Contributions to a health savings account; or
    • Amounts made available by an employer under a health reimbursement arrangement.
  • Application of the $2,500 Cap: The $2,500 cap is the maximum contribution for each employee, regardless of the number of dependents covered by the health FSA. If an employee participates in more than one health FSA sponsored by members of a controlled group or affiliated service group, the plans are aggregated and a single $2,500 limit applies to all the plans. However, if an employee is employed by two or more unrelated employers, he or she may elect up to $2,500 under each employer’s health FSA.
  • Short Plan Years: If a cafeteria plan has a plan year less than 12 months that begins after 2012, the $2,500 cap must be prorated based on the number of months in that short plan year.
  • Cost-of-living Adjustments: The $2,500 cap will be indexed for cost-of-living adjustments for plan years beginning on or after January 1, 2014. Employers who want to take advantage of cost-of-living adjustments each year should be sure to include such language when they amend their plans.
  • Employer Contributions (Flex Credits): The $2,500 cap does not apply to non-elective employer contributions, sometimes called flex credits. However, the credits will count against the $2,500 cap if the employee can elect to receive the flex credits as cash or as a taxable benefit.
  • Grace Period: Unused contributions may be carried over up to 2½ months into the next plan year. Any amounts carried over to the next plan year do not reduce the $2,500 cap for the next plan year, but instead count against the $2,500 cap of the plan year for which they were originally contributed.
  • Excess Contributions: If employees are erroneously allowed to elect more than $2,500 of salary reduction, the plan will continue to be qualified if: (1) the terms of the plan are applied uniformly to all participants; (2) the error was the result of a reasonable mistake by the employer; and (3) the amount contributed in excess of $2,500 is paid to the employee and reported as wages on the employee’s W-2 for the taxable year in which the correction was made. This relief is not available for employers under examination for plan years in which there was a failure to comply with the $2,500 limit.
  • “Use-or-lose” Rule: In light of the new $2,500 cap, the IRS is requesting comments and considering a change to the “use-or-lose” rule, which requires unused employee contributions to be forfeited at the end of the plan year. Comments must be submitted by August 17, 2012.