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Employee benefit plans come in many different varieties. One plan, called a "flexible spending arrangement" or "flex plan," allows employees to set aside pretax dollars to pay for qualified benefits. Now the IRS has come out with a new rule that will make these plans even more flexible � and more popular.

How It Works

Typically, with a flexible spending arrangement, the employee elects to have a certain amount deducted from her/his pay before taxes are taken out. Then, the money is put into an account that is used to pay the employee's qualified expenses.

Qualified expenses can include the costs of employer-provided group health coverage, dependent care assistance, dental plans, qualifying group-term life insurance, and adoption assistance, depending on the terms of the plan. Often, out-of-pocket medical expenses (i.e., those not covered under the employer's health plan) are reimbursed with pretax money set aside in the plan.

 One downside to a flexible spending arrangement is a rule providing that money set aside in a flex plan during one year cannot be used to pay expenses incurred in a subsequent year. This "use-it-or-lose-it" rule requires amounts remaining in an employee's flex plan account at the end of the plan year to be forfeited.

Example: Joe elects to participate in his employer's flexible spending arrangement having a plan year ending December 31. Joe defers $1,000 of his pay to his plan account during the year. At the end of the year, he still has $100 left in the account. Under the use-it-or-lose-it rule, the $100 would be lost.

New IRS Guidance

Recently, the IRS provided guidance with respect to the use-it-or-lose-it rule. The IRS now says an employer can give employees a two and one-half month grace period during which unused benefits or contributions could be used.

The new rule allows - but does not require - employers to amend their flexible spending arrangements to provide all participants with a grace period lasting no longer than two and one-half months after the plan year ends.

Qualified expenses incurred during the grace period may be paid or reimbursed from account balances remaining unused at the end of the immediately preceding plan year. Any payments for qualified benefits made during the grace period will be treated as though they were made for expenses incurred in the earlier plan year. 

Example: In the above example, Joe's employer adopts an amendment to its plan allowing participants a grace period of two and a half months after the plan year. On the February 15th following the plan year end, Joe incurs a $100 medical expense. The flex plan may reimburse that expense from the prior year's balance and, as a result, Joe would not forfeit the $100 balance remaining at the end of the prior plan year.

Impact on Participants

With this new guidance, the use-it-or-lose-it rule becomes less of a barrier to an employee's participating in a flexible spending arrangement. Now, a participant may have as long as 14½ months to use the benefits or contributions for a plan year before any amount would be forfeited.

There are, however, some restrictions on use of account balances during the grace period.

·        Unused contributions or benefits cannot be cashed out or converted to any other taxable or nontaxable benefit.

·        Unused money set aside for a specific benefit can only be used to pay or reimburse expenses for that benefit. Thus, money set aside
specifically for dependent care may only be used during the grace period for dependent care, not for another benefit such as medical expense reimbursement.

The IRS says employers may continue the current practice of providing a "run-out" period. The run-out period may extend after the end of the grace period, allowing additional time for expenses incurred during the plan year and grace period to be submitted and paid.

Steps To Take

An employer can adopt a grace period for the current plan year by amending the plan document before the end of the plan year. So, if you offer employees a flex plan with a plan year ending on December 31, 2005, you can provide a grace period for the 2005 plan year by adopting an amendment by that date.

Before you take any action, however, be sure to talk with one of our professionals, who can review your plan with you and help you determine which approach is best for you and your employees. And, if you don't already have a flexible spending arrangement, see us for more information about how such a plan might benefit your organization.


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