The massive Consolidated Appropriations Act, 2021, signed into law by the president on December 27, 2020, includes the Taxpayer Certainty and Disaster Relief Act of 2020 (the “Act”). The Act is intended to provide various forms of tax relief, including, among other things, temporary relaxation of the tax rules for health and dependent care flexible spending arrangements (“FSAs”). This benefits alert summarizes the temporary relief for FSAs and highlights important takeaways for plan sponsors.
Expanded carryovers and extended grace periods
As background, a primary feature of health and dependent care FSAs is the “use it or lose it” requirement. Under this requirement, unused funds in an FSA account at the end of the year are forfeited. Existing rules allow for a carryover of unused health FSA funds to the next plan year or a grace period in which unused funds can be used for claims incurred in the next plan year. Both of those exceptions to the use-it-or-lose-it requirement are limited: The health FSA carryover is capped at $550 (for 2020 and indexed thereafter) and the grace period cannot be longer than two and a half months. Further, health FSAs can allow a carryover feature or grace period, but not both.
Many FSA participants who elected to contribute to health and/or dependent care FSAs during open enrollment for the 2020 plan year may have done so in anticipation of upcoming elective healthcare procedures or in the expectation that their dependents would be in daycare or summer camp. Those expectations were probably frustrated by the COVID-19 pandemic, and therefore, many FSA accounts may have been over-funded by participants in 2020. To soften the blow of the use-it-or-lose-it requirement, the Internal Revenue Service (IRS) issued relief in May 2020 that allowed plan sponsors to extend the grace period to December 31, 2020, for the spend-down of unused 2019 contributions. It also allowed FSAs with carryover features to add the extended grace period for 2020. Given that the COVID-19 pandemic did not materially affect the United States until early spring 2020, the IRS relief described above was of limited usefulness.
The Act’s temporary relaxation of FSA rules goes much farther than the IRS relief. Details are as follows.
- Expanded Carryovers. In FSAs that permit carryovers, plan sponsors can amend their FSAs to allow all unused funds in the 2020 and 2021 plan years to be carried over into the next plan year. This applies to health FSAs and dependent care FSAs (previously, dependent care FSAs could not have a carryover feature).
- Extended Grace Periods. In FSAs that have a grace period, the grace period in which unused 2020 and 2021 plan year funds can be used in the next plan year can be extended to 12 months. In addition, similar to existing rules for dependent care FSAs, health FSAs may now permit terminated employees with unused funds to continue to receive reimbursements from their health FSAs for the rest of the plan year in which the termination occurred, plus any grace period.
- Special Carry Forward for Dependent Care FSAs. Normally, dependent care expenses for a child are only reimbursable until the child attains age 13 (except in cases of incapacity). The Act permits reimbursements for dependent children until age 14 during the 2020 plan year. For the 2021 plan year, a dependent care FSA participant may receive reimbursements for expenses for a child until the child reaches age 14, but only if the participant had unused funds in their account at the end of the 2020 plan year.
Prospective election changes
In general, employees must make elections to contribute to health and/or dependent care FSAs before the start of the plan year. Those elections are irrevocable, subject to permitted mid-year election change events, such as changes in marital status, number of dependents, employment, dependent care costs, etc. The IRS previously granted relief from the irrevocability requirement in its May 2020 relief by allowing prospective election changes. Given that the COVID-19 pandemic will cause considerable uncertainty with respect to healthcare costs and dependent care expenses throughout 2021, the Act continues the IRS relief for health and dependent care FSAs for plan years ending in 2021.
The Act’s temporary relief from the FSA use-it-or-lose-it and election irrevocability rules give FSA participants greater flexibility in managing their health and dependent care expenses in a time of uncertainty. However, plan sponsors and administrators should consider the following before adopting the changes:
- As with the May 2020 IRS guidance, these changes are optional. Although the relaxed rules certainly benefit participants, adopting the temporary rules will increase costs for plan sponsors. An important characteristic of FSAs is that the full annual contribution amount be available to participants on the first day of the plan year. If a participant terminates employment having spent more FSA funds than the participant contributed, the FSA incurs an experience loss. These experience losses are typically offset, at least to some extent, by experience gains from forfeitures due to the use-it-or-lose-it requirements. Plan sponsors adopting the Act’s relaxed carryover rule or expanded grace period should expect fewer experience gains to offset experience losses.
- Plans sponsors that elect to adopt the expanded carryover or extended grace period rules should notify participants of the changes as soon as possible. Given that the end of 2020 is only a day away, most FSA participants have already made their elections for the 2021 plan year. Participants may have made their elections based on the expectation of a limited carryover and a short grace period, so to the extent that more funds will be available in 2021, participants may need to change their elections.
- If a health FSA is amended to temporarily permit terminated employees to continue participation for the remainder of the plan year (plus any grace period), plan administrators should coordinate the new process with the plan sponsor’s COBRA procedures. Normally, after termination of employment, health FSA participants who have not overspent their account have the right to elect COBRA continuation coverage. If the Act’s temporary relief is adopted, however, there would generally be no loss of coverage to trigger a COBRA election right.
- The Act’s relaxed election change rules for the 2021 plan year are generally straightforward: Any election change is permitted as long as it is prospective. Nevertheless, plan sponsors should consider whether they should place any limits on the election changes. To mitigate against experience losses, a participant should not be permitted to elect a new annual contribution amount that, as of the election change date, is less than the greater of the amount contributed in 2021 and the amount of reimbursements received in 2021. To manage the administrative burden of implementing the election changes, plan sponsors should also consider whether to limit the number of election changes that participants can make.
- FSA plan documents do not have to be amended to accommodate these changes until the end of the plan year after the year in which the changes are implemented. The amendment should be adopted retroactively to the date on which the changes were implemented, and the FSA should be operated consistently with the amended provisions during the interim period. Plan sponsors should keep the amendment deadline in mind to preserve the favorable tax status of their FSAs.
Plan sponsors considering whether to make these changes and communicate the new rules with their employees should consult with their legal advisors to ensure compliance with applicable laws and regulations.