FSAs: Now With More Grace!

Flexible spending arrangements are a beautiful thing. They allow you to pay otherwise nondeductible expenses (or perhaps partially deductible expenses) with pre-tax dollars through your employer's cafeteria plan. For example, you might designate $500 against your FSA to be used to pay medical expenses that you'll incur during the year. Once you provide the necessary documentation to your employer, these payments can be made and you will not recognize any taxable income. And that $500 in medical expenses would likely be well below the deductible amount to recognize any tax savings. So in effect, you converted an otherwise nondeductible expense into one on which you'll pay no taxes. It's really a very powerful program.

But one of the drawbacks to using FSAs were the "use it or lose it" rules. That means that if you didn't actually spend the amounts that you actually designated in your FSA account, they would be lost forever. You couldn't "carry over" those amounts to another year. If any of your allocated FSA amounts were "lost," you basically realized a pay decrease with nothing to show for it. Bummer.

For that reason alone, many folks were either not using their FSA account or not using it to the maximum benefit. But there are new changes to the FSA plans. IRS Notice 2005-42 (found in Internal Revenue Bulletin 2005-23) now allows for a "grace period" of up to two and a half months after the end of the plan year in which to spend any remaining funds. In effect, you now have 14 months and 15 days in which to "use up" your FSA funds. Let's look at an example.

Old rules: Dena is a participant in her company's pre-tax section 125 cafeteria plan, which runs on a calendar plan year (January through December). In 2004, Dena signs up for an election of $2,000 but uses only $1,700 throughout the year. The company does have a grace period of 60 days, which means that Dena had through Feb. 28, 2005 to gather and submit any claims that occurred during the 12-month plan year (Jan. 1, 2004 through Dec. 31, 2004). If Dena didn't have any eligible claims to submit, she will forfeit the unused $300.

New rules: Dena is a participant in her company's pre-tax section 125 cafeteria plan, which runs on a calendar plan year (January through December). In 2006, Dena signs up for an election of $2,000 but uses only $1,700 throughout the year. Dena may now go out and incur expenses from Jan. 1, 2007, through March 15, 2007, to submit eligible claims for reimbursement toward her unused 2006 election of $300 to avoid forfeiture of these dollars.

This new ruling helps ease the burden of estimating the upcoming year's worth of medical, dental, and vision expenses knowing that you have an additional two and a half months to use up the funds, if needed. Note that employers may choose to also allow over-the-counter (OTC) expenses to be used within their plan, which means if you, as a participant, have a small amount of unused funds toward the end of your plan year, you can run out and purchase some eligible OTC items to use up your funds.

Typically, in the past, employers have utilized a 31-day, 60-day, or 90-day grace period to allow employees to submit claims that occurred during the plan year. If your company wants to adopt this new ruling and ease the estimating "use-it-or-lose-it" burden of the employees, the company must amend its cafeteria-plan document before the end of the plan year (likely before the end of 2005) in which the provisions is to be implemented. That means that the new grace-period provisions could be put into place as early as the 2005 plan year, should your employer decide to amend the cafeteria plan. But even given company delays in amending their plans, most employers should certainly be able to amend their plans by 2006, thereby giving employees the opportunity to avail themselves of this new grace period.

While this notice is still brand new, it's never too early to discuss these changes with the human resources and/or benefits professionals in your company in order to not only make they aware of the new provisions, but to also inquire as to the possibility of implementation in the near future.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.