Regarding health insurance, cafeteria plans are also known as Section 125 plans or flexible spending accounts (FSAs). These allow employees to contribute to a tax-advantaged savings account and withdraw money as needed to fund a variety of medical expenses.
Cafeteria plans are flexible and financially sensible, but regulations proposed in the 1980s hinged a restrictive use-it-or-lose-it clause to the plans. Participants were required to forfeit unused benefits and contributions at the end of the plan year, and using contributions made during a plan year to purchase benefits in a subsequent year was prohibited.
Responding to public and congressional pressure, the IRS modified cafeteria plans in May 2005, alleviating participants from this clause. Notice 2005-42, applicable to Section 125 cafeteria plans, enacts a grace period. Now, participants can roll over contributions and use funds to reimburse expenses for two-and-a half-months following the end of the plan year.
In the past, employees have been reluctant to contribute to FSAs because they were afraid that they would contribute too much and lose money at the end of the year. For example, suppose an employee contributed $1,000 to an FSA and has $200 remaining in the account at the plan year ending Dec. 31, 2005.
With the grace period, the $200 could be used to reimburse medical expenses incurred from Jan. 1, 2006, through March 15, 2006. If the employee incurred a $150 expense on March 1, 2006, he could apply the unused $200 balance from the 2005 plan year to reimburse the expense.
But keep in mind, because the grace period is two-and-a-half months, the employee must forfeit the $50 if it is not used by March 15, 2006.
The grace period provides greater opportunity to maximize the benefits of FSAs, but first, employers must understand some key factors and communicate these requirements to employees. A benefits administrator can provide further information on these keys.
- Plan amendment required. Employers must amend their plans by the end of the current plan year for employees to adopt the grace period.
- Contributions cannot be converted to other benefits. Unused benefits or contributions cannot be converted to other taxable or nontaxable benefits during the grace period. For example, a participant cannot apply unused FSA contributions to reimburse dependent care expenses incurred during the grace period.
The cafeteria plan only permits rollover reimbursements for the same qualified benefits.
- The use-it-or-lose-it rule still applies. In other words, if after two-and-a-half months, an employee still has $30 in unspent contributions, he or she will forfeit this contribution.
- Run-out period allowed. Following the grace period, the cafeteria plan may allow for a run-out period. During this time, participants can apply for reimbursements for expenses incurred during the plan year and grace period.
Jessica Galardini is COO of the Chambers of Commerce Service Corp. and executive vice president and COO of HRH Affinity Marketing Group. Reach her at (412) 456-7012.