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IRS: Why Keep the FSA Use-It-or-Lose-It Rule?

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The Internal Revenue Service (IRS) says the new $2,500 cap on workers’ annual flexible spending arrangement (FSA) contributions may make the much-hated use-it-or-lose-it rule obsolete.

The IRS created the use-it-or-lose-it rule in the first place to keep a high-paid worker from abusing the program by using an FSA to defer paying  paying taxes by feeding a large amount of salary into the FSA, officials say in IRS Notice N-12-40.

Now that the Patient Protection and Affordable Care Act of 2010 (PPACA) has set a relatively low limit on annual contributions, the IRS might be able to provide at some administrative relief, officials say.

“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,” officials say. “Comments are also requested on how any such modifications would interact with the $2,500 limit.”

IRS officials also talked about how they will implement the $2,500 contribution cap.

The limit, established in Section 125(i) of the Internal Revenue Code, will apply to plan years starting after Dec. 31, 2012.

The IRS will start indexing the $2,500 limit for plan years starting after Dec. 31, 2013.

A cafeteria plan offering a health FSA must be amended to include the new $2,500 contribution limit, officials say.

If a worker exceeds the limit due to a “reasonable mistake,” and “not willful neglect,” and the employer corrects the error, the cafeteria plan associated with the FSA will continue to qualify to be an Internal Revenue Code Section 125 cafeteria plan, officials say.

The relief for errors will not be available if an employer is already facing an examination involving concerns about the cafteria plans during which the excess FSA contributions occurred, officials say.

Comments on the notice are due Aug. 17.

Benefits compliance specialists at Lockton Companies L.L.C., Kansas City, Mo., say the $2,500 limit does not appear to “apply to employer-provided flex credits that cannot be converted to cash or applied to taxable benefits, such as 401(k) plan contributions or the purchase of vacation days.”

“Few employers supply these sorts of credits under a cafeteria plan, however,” the compliance specialists say.