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Notice 2020-29 Makes Health Flexible Savings Accounts More Flexible

In June, 2020, the Internal Revenue Service (IRS) issued Notice 2020-29 to provide increased flexibility under section 125 of the Internal Revenue Code (Code) in connection with employer-sponsored health coverage, health Flexible Spending Arrangements (FSAs) and dependent care assistance programs.

What is Section 125?

Section 125 of the Code sets forth the rules for what is commonly known as a “cafeteria plan”.  A cafeteria plan is a written plan maintained by an employer under which an employee can choose between cash and “qualified benefits”.  A “qualified benefit” is any benefit, which is excluded from an employee’s taxable income under another section of the Code and may include employer-sponsored health plans and FSAs, which are excludable under sections 105 and 106 of the Code, and dependent care assistance programs, which are excludable under section 129 of the Code.  In simple terms, under a cafeteria plan, an employee can choose to receive his or her full salary, as taxable income, or divert a portion of that salary on a tax-exempt basis to pay for certain benefits, such as medical care.

What is a Health FSA?

A health FSA is an account maintained by the employer for the benefit of an employee.  It is funded by salary reductions by the employee and used to reimburse the employee for qualified medical expenses.  The amount that an employee may divert to a health FSA is limited.  In 2020, an employee may contribute up to $2,750 to his or her health FSA.

In order to avoid FSAs turning into plans of deferred compensation, an employee was initially required to spend all of the funds in his or her FSA during the applicable plan year.  Any funds not spent were forfeited.  This was known as the “use-it-or lose-it” rule.  Over time, two exceptions to the “use-it-or-lose-it” rule were adopted by the IRS – the grace period rule and the carryover rule.

What is the Grace Period Rule?

The first exception is the “grace period” rule.  Under the grace period rule, a plan may allow an employee to apply unused amounts, left over at the end of the plan year, to qualified medical expenses incurred during the first two months and 15 days of the next plan year.

What is the Carryover Rule?

The “carryover” rule permits an employee to carryover a limited amount to the next plan year for qualified medical expenses incurred during the entire following plan year.  The amount that an employee could carryover from 2019 to 2020 was $500.  That amount has been increased for the 2020 plan year to $550.

A plan can provide for either a grace period or a carryover, but not both.  In addition, a plan can provide for neither.

What Does Notice 2020-29 Do?

Generally, an employee must make an election regarding his or her employer’s cafeteria plan before the start of the applicable plan year.  Mid-year changes to an employee’s election may be made only in limited circumstances.

In Notice 2020-29, the IRS recognizes the impact of the Covid-19 crisis on the health of employees and provides greater flexibility in making changes mid-year.  More specifically, Notice 2020-29 provides that an employer may amend its plan to allow an employee to:

  1. make a new election to participate in an employer-sponsored health plan on a prospective basis, if the employee initially declined to participate in the plan;
  2. revoke an existing election to participate in an employer-sponsored health plan and make a new election to participate on a prospective basis in a different plan sponsored by the employer;
  3. revoke an existing election to participate in an employer-sponsored health plan and not participate in any plan offered by the employer as long as the employee attests in writing that the employee either is enrolled or will enroll in another health plan, not sponsored by the employer, such as a plan sponsored by the employee’s spouse;
  4. revoke an election, make a new election or decrease or increase an existing election regarding a health FSA on a prospective basis; and
  5. revoke an election, make a new election or decrease or increase an existing election regarding a dependent care assistance program on a prospective basis.

Notice 2020-29 also permits an employer to make a change to its plan to extend its plan’s grace period.  If a plan has a grace period that ends in 2020 or if the plan has a plan year that ends in 2020, the employer can extend the grace period to December 31, 2020.  This extension of time is also available to plans that provide for a carryover, notwithstanding the rule that a plan can either have a grace period or a carryover, but not both.

Plan Amendments

The changes made by Notice 2020-29 are permissible, not mandatory.  An employer can choose to amend its plan, or it can choose to not make any changes.  If an employer chooses to amend its plan to adopt one or more of the changes permitted by the Notice, it must do so by written amendment.  An amendment for the 2020 plan year must be adopted by December 31, 2021, and made retroactive.  However, the employer must provide written notice of the amendments to its employees and operate the plan as if the amendments had already been adopted.

Considerations

There are many factors that an employer must take into consideration when deciding whether to amend its plan.  For example, an employer may want to impose conditions on an employee’s election in order to avoid adverse selection.  Contact your RMC representative to discuss the best path forward for your cafeteria plan.