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IRS to Modify FSA Use-It-or-Lose-It Rule?

Written by Nickel - 10 Comments

I’ve always hated the use-it-or-lose-it rule that governs flexible spending accounts. In case you weren’t aware, if you set aside money into an FSA and then fail to spend it by the end of the year*, you lose the money. I’m guessing that the goal here is to prevent people from stockpiling vast sums of cash, but it’s a horrible rule.

*Note: Yes, there is a 2.5 month grace period that extends into the next year during which you can make claims, but the actual spending needs to occur during the plan year.

IRS to Modify FSA Use-It-or-Lose-It Rule?

The one positive side effect of this rule for those who switch jobs mid-year is that they can potentially profit from their FSA. That is, you can pull money out faster than you put it in, so if you max out your FSA withdrawals and then leave your job, your employer is left holding the bag — but don’t feel too bad; they also get to keep any forfeited amounts.

The obvious alternative to the use-it-or-lose-it rule would be to simply adjust your annual contribution limit down by the amount of money remaining in your FSA at the end of the year. So, for example, if you contribution limit was $5,000/year** and you had $2k left over at the end of the year, your limit for the next year would be $3k.

*Note: Effective in 2013, there will be a federally-mandated cap of $2,500/year (indexed for inflation) on FSA contributions. Previously, there wasn’t a hard limit, though most employers capped things at $5k/year.

Well, when the IRS and the Treasury Department recently announced details of upcoming changes to these so-called cafeteria plans, they also solicited comments on possible changes to the use-it-or-lose-it rule. Here’s what they had to say:

In light of the $2,500 limit, the Treasury Department and the IRS are considering whether, for health FSAs, the position contained in proposed regulations that is often referred to as the “use-or-lose” rule should be modified.

[…]

The $2,500 limit, while not addressing the “use-or-lose” rule, limits the potential for using health FSAs to defer compensation and the extent to which salary reduction amounts may accumulate over time. Given the $2,500 limit, the Treasury Department and the IRS are considering whether the use-or-lose rule for health FSAs should be modified to provide a different form of administrative relief (instead of, or in addition to, the current 2½ month grace period rule). Comments are requested on whether the proposed regulations should be modified to provide additional flexibility with respect to the operation of the use-or-lose rule for health FSAs and, if so, how any such flexibility might be formulated and constrained. Comments are also requested on how any such modifications would interact with the $2,500 limit.

If you’re interested in making comments, you should send them by mail to:

CC:PA:LPD:PR (Notice 2012-40)
Room 5203, Internal Revenue Service
P.O. Box 7604, Ben Franklin Station
Washington, DC 20044

or via courier to:

CC:PA:LPD:PR (Notice 2012-40)
Courier’s Desk, Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20044

to via e-mail to:

Notice.comments@irscounsel.treas.gov

When contacting them about this, be sure to include an explicit reference to Notice 2012-40.

Published on June 6th, 2012
Modified on November 12th, 2012 - 10 Comments
Filed under: Taxes

About the author: is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

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10 Responses to “IRS to Modify FSA Use-It-or-Lose-It Rule?”

  1. 1
    Jack Says:

    Wow, at a time when health care costs are going up up up, they think the annual FSA limit needs to be set at 2500? Do you know if this change is planned for dependent spending accounts as well? Daycare costs easily exceed 2500 a year.

  2. 2
    Carl Lassegue Says:

    Last year we overestimated the amount our health related expenses and we put too much in our FSA. I ended up having a dental procedure at the end of the year just so I don’t lose the money. I’m glad to hear that they are considering changing that rule!

    What is your opinion of the proposed new cap? Do you think it’s too low or just right?

  3. 3
    PC Says:

    This might not be an immediately popular idea. I suggest FSAs should end. Why ?

    FSAs are indeed a useful tax saving benefit for the many that have them available. Its limited to a few thousand dollars per year, typically, and features the famous ‘use it or lose it’ rules. Given the tax break, assuming you use up your full contribution, then it saves something like 20-40%. So say you contribute AND USE $2500 and margin tax is 30%, youve avoid a nice $750 of tax. Great. So why do I propose that FSAs should end ?

    1) Bureaucracy : FSAs cost employers time and effort to maintain, typically employing a third party. This third party is simply a paper pusher with a system to interpret odd rules and processes. FSA processors do not create value in our economy, they merely push paper around. Gee, my FSA processor doesnt even keep records and diligently reminds us that it is up to the employee to retain records in event of audit. Lets cut out bureaucracy; FSAs have just created more in exchange for a curious tax law.

    2) Time : don’t you find it frustrating to be saving receipts, explanation of benefits and other documents to then copy/mail/fax/followup ? Sure I like to save say $750, and I do so, but really, all the fiddling around with paper and mailing it off, having it rejected for ‘lack of documentation’, finding MORE documentation, re-filing, NOT productive !……..FSAs have just created more bureaucracy and burnt my time that could better be used doing productive work.

    3) Bigger purpose and tax law : most agree our tax code is way to large and complex, so what bigger purpose do FSAs serve ? Seems to me they create just MORE tax law ?

    4) ‘Use it or lose it’ Why ? Why in any sane tax code would you have such a rule ? For what purpose. To encourage folks to spend MORE on healthcare !! This means FSA participants have to attempt to ‘guess’ their healthcare costs and when they overestimate, they end with trying to find dental or other procedures and items to ‘burn the money on’. I won’t say where, but there are places on the internet vaguely alluding to “hey, buy some crazy expensive medical device, burn your FSA, then return the device for refund”. Great, now we need to combat FSA fraud from the unscrupulous !

    5) Yet more bureaucracy : years ago, you could pay for over the counter medications and medical supplies via FSA. That ended after the (IRS ?) decided that only medications with ‘medical need / Rx’ qualified. Over the years, the list of eligible, ineligible, may-be eligible under certain circumstances, has evolved and changed. Some office of people need to maintain this list, goodness, there is even an industry built up around advising what is or is not eligible. Parking expense for a doctors visit IS eligible, but vitamin C for general wellness is not. Why ?? What reason allows for ‘parking’ but not ‘vitamins’ ? This eligible/non-eligible list is a fascinating and lawyerly work, is bureaucracy and costs money. Cut it out.

    6) Dentist like FSAs. They like to see if their patients have any leftover FSA funds; they can always find some more teeth to clean or fill. Amber alert to me about a broken system when my dentist asks if I have any FSA fund left !!

    7) Cost. Cutting a tiny tax break does not change the underlying cost of medicine. Cutting individuals a little if complex tax break doesnt change the underlying problem and has no real purpose. Gas is expensive ! Lets all have FSAs for gas ! Goodness, airfares are going up, lets have airfare FSAs ! Internet access is pretty much essential in modern life, costs are going up, why not ‘internet access’ FSAs !

    I write this as a beneficiary of an FSA which has notionally ’saved’ me several thousand $.

    [sorry for the long post Nickel, feel free to trim/edit if you wish, I hope its interesting and worthwhile]

  4. 4
    Steve Says:

    Just to clarify, employers are allowed to have a grace period, but not required to.

    I agree with PC. The benefit of these things is not really worth the effort IMHO. But then I have a high enough income that $750 is not make-it-or-break-it for my household. Still, I kinda doubt many below average income households are using FSA accounts.

  5. 5
    PC Says:

    @ Steve, appreciate you taking the time to read my long post !

    I thank you for the clarification, “Just to clarify, employers are allowed to have a grace period, but not required to.”

    Nickel quoted “Yes, there is a 2.5 month grace period that extends into the next year during which you can make claims, but the actual spending needs to occur during the plan year.”

    Actually, I believe that there exists a grace period which employers may (but are not obliged) to offer and that this grace period extends to approx March 15 and allows to you incur expenses. So for 2011 FSA year, for employees whose employers offer this grace period, they can in fact INCUR expenses from 1/1/12 thr approx 3/15/12. As I’ve learnt, this introduces more complexity. FSAs with attached ‘debit cards’, typically will charge to the ‘current calendar year FSA’. So for example, say it is 14 Mar 2011 and you have funds left over from 2011 FSA AND you have a new 2012 FSA. Using the debit card would typically deduct from the 2012 FSA. Of course, you don’t want that, you want the charge deducted from the 2011 FSA to use it up ! So now, you are back to submitting bits of paper to the paper shufflers.

    Yep, my clarification to your clarification of the original post supports my main idea, FSAs are more complicated and bureaucratic than they are worth. Get rid of them.

    More here :
    http://library.findlaw.com/2005/Aug/24/194482.html

  6. 6
    Tension Says:

    This is replacing one bad rule with another. It will be a nightmarebto keep track of the limits across multiple years and multiple employers (if one happens to change jobs). Not to mention across multiple people (if both spouses are working).

    Why not keep it simple? Limit to remain 5k. Whatever is spent on qualified expenses is taxfree. Rest of the amount is returned to othe employee at the end of year (or end of employment).

  7. 7
    Tension Says:

    @PC: agree that 2500 limit is a joke and not worth the hassle. One nitpick though – FSA contributions are exempt from payroll taxes too (soc sec and med) and not just fed taxes.

  8. 8
    Catherine Says:

    As soon as my employer offerred the option to switch to a high deductible plan, we took it and contribute to an HSA instead. No more use it or lose it worries. No claim deadlines. And I can invest that money in mutual funds.

    Reduction in premiums more than covers the deductible while leaving enough to contribute the max each year. HDHP’s and HSA’s are under appreciated.

  9. 9
    Jim Donaught Says:

    Twice, my family has gotten screwed by having planned surgeries postponed; in both cases the procedures were re-scheduled to dates after December 31. We’re talking several thousand dollars lost, for no good reason other than an idiotic rule.
    Returning unspent money (less taxes due) to the employee would be simple, fair, and sensible. I guess the latter feature is what rules it out. Better yet, just make medical expenses deductible, period, without the 2% exclusion, and get rid of this whole ridiculous system.

  10. 10
    Camille Says:

    @Jim Donaught,
    totally agre with you,. Why the “loose it rule”? return the money to the employee. We moved in the middle of 2011 to another state and totally forgot about our FSA. The plan manager is telling us “though luck” but your savings are lost. We paid for daycare all year and can’t even expect a break from the money we sat aside from our pay check.

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