IRS Relaxes Rules on Healthcare Flexible Spending Accounts

The IRS has relaxed healthcare FSA rules to allow employees to change their healthcare contributions, including dropping them altogether, going forward. But the employer can choose to amend its FSA, or not.

Last week we discussed a recently revised IRS guidance that allows for mid-year changes to dependent care Flexible Spending Accounts (FSAs). The taxing agency also provided similar relief for the even more popular healthcare FSAs that allow pretax employee contributions to employer-sponsored FSAs to cover unreimbursed medical expenses. Fun Fact: Over 22 million workers participate in healthcare FSAs, four times as many as use dependent care plans.

Healthcare FSA Review

Healthcare Flexible Spending Accounts (FSAs) are popular among workers. However, like dependent care FSAs, they have become potential liabilities for participants who set aside hundreds… even thousands... of dollars to pay for medical care that might no longer be accessible due to the Covid-19 virus. Healthcare plans allow for $2,750 in pretax contributions to cover out-of-pocket qualified healthcare expenses for the worker, his/her spouse, and dependents. A married worker’s spouse can contribute $2,750 to another healthcare FSA with his or her employer. This represents a significant savings to employees who avoid paying federal income and FICA taxes on the pretax paycheck withdrawals. Employers benefits, too, because they avoid paying the 7.65% employer FICA tax match.

Use It or Lose It

Like the dependent care FSA, the tax-advantaged healthcare version includes an onerous “use it or lose it” feature. Quite simply, if a healthcare FSA participant doesn’t use the money set aside for unreimbursed medical bills within the plan year, the unspent funds are forfeited to the employer. And here’s the Covid-19 rub. Because folks have delayed so many elective surgeries, dental procedures, and other non-emergency medical treatments during the height of the pandemic – and because so many have been reluctant to reschedule such treatments – money set aside in the plan could go unused… and forfeited.

COVID-19 Connection

The new IRS guideline allows – but does not require – employers to amend their plans. The revision allows employees to change their healthcare contributions, including dropping them altogether, going forward. But the employer can choose to amend its FSA, or not. And as to that innocent sounding “going forward” caveat, the employee must spend the money already deducted from his paycheck in the current plan year. Of note, most employers support this change and will likely participate.

The benefit of these rule changes allow the Covid-19 impacted worker to opt out of making contributions during a plan year, an option not previously permitted before, except under restrictive circumstances. At their option, employers may allow either a 75-day grace period after the end of the plan during which any remaining healthcare FSA funds can be spent or grant the ability to roll over up to $550 of unused funds into the next plan year, but not both.

With regard to the money already set aside but yet unused, workers can spend it on certain out-of-pocket medical care to include deductibles and co-payments (but not premiums), dental work, eyeglasses, prescription medications, medical equipment, transportation costs, parking and mileage expenses when making doctor visits, and the like. Also, the IRS healthcare rules had already been tempered a bit by the earlier Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which will allow workers to use “captive” contributions on such expenditures as over-the-counter medicine and feminine hygiene products.

Fair Or Unfair… To Whom?

A worker’s designated annual pretax contribution to a healthcare FSA is “preloaded”… available for use on day one of the plan year. Workers reimburse the employer FSA’s disbursed funds incrementally through paycheck deductions during the plan year. In short, an employee can be reimbursed for a full year’s plan contribution before paying back a penny. And the employer cannot recover unreimbursed funds if the worker is terminated before the balance is repaid. Seems unfair to the employer until we’re reminded that any unused worker contributions at the end of the plan year revert to the employer. Further, if a worker is terminated for whatever reason before all of a given year’s funds are spent, the remaining contributions revert to the employer.

IRS Guidance Summary

Here is the IRS notice in black-and-white:

IRS (2020-95, May 12, 2020) Notice 2020-29

Provides greater flexibility for [workers] by extending claims periods to apply unused amounts remaining in a health FSA for expenses incurred for those same qualified benefits through December 31, 2020; and by expanding the ability of taxpayers to make mid-year elections for health FSAs programs, allowing them to respond to changes in needs as a result of the COVID-19 pandemic.

Notice 2020-33

Responds to Executive Order 13877, which directs the Secretary of the Treasury to "issue guidance to increase the amount of funds that can carry over without penalty at the end of the year for FSA arrangements" from $500, to a maximum of $550, as adjusted annually for inflation.