IRS Provides Guidance on $2,500 FSA Limit
In late May, the IRS issued Notice 2012-40, which offers long-awaited guidance on the $2,500 limit on Health FSA salary reduction contributions. This rule is effective in 2013 under the Affordable Care Act (ACA).
Effective Date - The IRS stated that Health FSAs with plan years starting in 2012 (e.g., non-calendar plan years) do not have to comply with the $2,500 limit (indexed for inflation) until the plan year that starts in 2013.
Definition of taxable year - Because Health FSAs operate under a “plan year,” the IRS concluded that all references to “taxable year” under §125(i) actually mean “plan year.” This is good news for employers with non-calendar plan years because it means that they don’t have to track salary reduction contributions for each calendar year.
Grace periods - Any amounts carried over into a grace period (i.e., the extra two months, 15 days permitted after the plan year ends, by plan design) do not apply toward the Health FSA limit for the following plan year. For example, for the 2012 plan year, amounts carried over to the grace period for January 1, 2013–March 15, 2013, do not count toward the $2,500 limit for the 2013 plan year.
Special spousal rule - The Health FSA limit applies on a participant basis. Therefore, both spouses are subject to a separate $2,500 limit (indexed for inflation), even if they work for the same employer.
Plan amendments - Employers must amend their cafeteria plans to reflect these limits. The IRS graciously allowed employers extra time to execute those amendments. The deadline is December 31, 2014.
Short plan years - A short plan year (i.e., fewer than 12 months) that starts in 2013 must prorate the limit based on the number of months of the plan year. For example, a short plan year of January 1, 2013–June 30, 2013, would be subject to a $1,250 salary reduction contribution limit.
Plan year changes - The IRS reminded us that any plan year change, including short plan years, must be for a valid business purpose. Delaying the application of the $2,500 limit is not a valid business purpose.
Reasonable mistakes - If an employee erroneously elects more than the allowable limit and the employer makes a reasonable error not due to willful neglect, the employer may correct the mistake by reclassifying the amount above the limit as W-2 taxable income. The employer must do this for the tax year in which the plan year ends.
Other Reminders - The IRS reminded us that the controlled group/common ownership rules apply to the $2,500 limit (indexed for inflation) just like they do for other Health FSA issues. The Health FSA limit is indexed for inflation and will change after 2013. The $2,500 limit only applies to salary reduction contributions. It does not apply to employer contributions, including flex credits. The limit does not apply to Dependent Care FSAs, HSAs, HRAs or adoption care assistance.
Use-or-Lose Rule may end - The IRS requested written comments by August 17, 2012, as to whether this rule should be modified in light of §125(i).