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Distributed June 7, 2012

Maximum Health FSA Salary Reductions in 2013

As a result of the Patient Protection and Affordable Care Act of 2010 (PPACA), health flexible spending account (FSA) salary reductions are being limited to $2,500 for taxable years beginning on or after January 1, 2013. Until recently, the term "taxable year" had yet to be defined. However, the IRS released Notice 2012-40, which clarifies the term and provides guidance on the effective date of the statutory limit, the deadline for plan amendments, and relief for contributions that mistakenly exceed the maximum limit. In addition, the Notice requests comments on the modification of the use-it-or-lose-it rule as it applies to health FSAs.

Taxable Year Definition

A taxable year in Internal Revenue Code Section 125(i) refers to the plan year of the cafeteria plan. The elected health FSA salary reductions apply for this period.

Compliance with the $2,500 Salary Reduction Limit

The $2,500 limit on health FSA salary reduction contributions applies on a plan year basis, and the new statutory limit does not apply for plan years that begin before January 1, 2013. The Notice provides the clarification needed for FSA plans that do not follow a calendar year, and such plans do not need to adopt the maximum limit until the beginning of their 2013 plan year. Plans with a short plan year that begins after December 31, 2012 must prorate the $2,500 limit based on the number of months in the short plan year.

The new health FSA election limit applies on an employee-by-employee basis, so $2,500 is the maximum amount each employee can contribute for a plan year beginning on or after January 1, 2013. This is regardless of the number of other individuals (i.e., spouse, dependents, or adult children) whose health care expenses are reimbursable under the employee's health FSA. In addition, if each of two spouses is eligible to elect salary reduction contributions to a health FSA, each spouse may elect to contribute up to $2,500 to his or her health FSA. This applies even if both participate in the same health FSA sponsored by the same employer.

After December 31, 2012, a plan that fails to comply with the health FSA statutory limit will not be considered a Section 125 cafeteria plan. If applicable, the value of the taxable benefits that the employee could have elected under the plan during the plan year must be included in the employee's gross income.

Please note: The $2,500 limit applies on a plan year basis and is effective for plan years beginning after December 31, 2012. The statutory limit will be indexed for cost-of-living adjustments for plan years beginning after December 31, 2013.

Cafeteria Plan Amendments

Employers offering health FSA plans must take action and adopt the required cafeteria plan amendments to reflect the $2,500 limit. Typically, cafeteria plan amendments can only be made on a prospective basis; however, this new plan amendment deadline is December 31, 2014, and the amendment may be retroactive only if the FSA plan adopts and operates in accordance with the statutory requirements for plan years beginning after December 31, 2012.

Health FSA Plans with a Grace Period

For health FSAs with plan years beginning in 2012, unused salary reduction contributions to a health FSA plan may be carried over into the two-month and 15-day grace period for that plan year. The funds carried over into the grace period for the 2012 plan year will not count against the $2,500 limit for the 2013 plan year.

Relief for Contribution Mistakes

For certain salary reduction contributions that exceed the $2,500 limit, relief is available if due to a reasonable mistake and not intentional neglect. If applicable, the employer (or the employer's agent) must address and correct the mistake. Additional guidance is available in the Notice.

Exceptions to the Capped Maximum

The statutory $2,500 limit only applies to salary reduction contributions under a health FSA and does not apply to certain employer non-elective contributions (sometimes referred to as "flex credits"). The provision does not apply to contributions made to other types of FSAs (i.e., dependent care FSA), health savings accounts (HSAs), or health reimbursement arrangements (HRAs). In addition, salary reduction contributions to cafeteria plans that are used to pay for an employee's share of health coverage premiums (or the corresponding employee share under a self-insured employer-sponsored health plan) are not affected.

Use-it-or-lose-it Rule Comments

The Treasury Department and the IRS are considering modifications to the use-it-or-lose-it rule for health FSAs. Under this rule, unused health FSA funds are forfeited at the end of the plan year. A request for comments has been released to gather input regarding if the proposed regulations should be modified to provide additional flexibility for carried-over health FSA funds and how modification would interact with the $2,500 limit. Comments must be submitted to the IRS by August 17, 2012 and should include reference to Notice 2012-40.

Please review Notice 2012-40 on the IRS website for further guidance. Within the Notice, you can also find the submission details for use-it-or-lose-it comments.

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