3516 / What is a health flexible spending arrangement?

Although health coverage under an FSA need not be provided under commercial insurance, it must demonstrate the risk shifting and risk distribution characteristics of insurance. Reimbursements under a health FSA must be paid specifically to reimburse medical expenses that have been incurred previously. A health FSA cannot operate so as to provide coverage only for periods during which the participants expect to incur medical expenses, if such period is shorter than a plan year. In addition, the maximum amount of reimbursement must be available at all times throughout the period of coverage (properly reduced for prior reimbursements for the same period of coverage), without regard to the extent to which the participant has paid the required premiums for the coverage period, and without a premium payment schedule based on the rate or amount of covered claims incurred in the coverage period.¹ Before 2013, there was no statutory limit on contributions to a health FSA, but most employers imposed a limit to protect themselves against large claims that had not yet been funded by salary reductions.

The period of coverage must be 12 months, or in the case of a short first plan year, the entire first year (or the short plan year where the plan year is changed). Election changes may not be permitted to increase or decrease coverage during a coverage year, but prospective changes may be allowed if they are consistent with certain changes in family status. See Q 3506. The plan may permit the period of coverage to be terminated if the employee fails to pay premiums, provided that the terms of the plan prohibit the employee from making a new election during the remaining period of coverage. The plan may permit revocation of existing elections by an employee who terminated service.²

A plan may provide a grace period of no more than 2½ months following the end of the plan year for participants to incur and submit expenses for reimbursement. The grace period must apply to all participants in the plan. Plans may adopt a grace period for the current plan year by amending the plan document before the end of the current plan year.³ Further, beginning in 2014, health FSAs may be amended so that $500 of each participant’s unused amounts remaining at the end of the plan year may be carried forward to the next plan year. However, plans that incorporate the carryover provision may not also offer the 2½ month grace period.⁴

In 2020, the IRS clarified that the amount that may be carried forward will be inflation-adjusted, so that the amount that can be carried over to the following year from a health FSA will equal 20 percent of the maximum inflation-indexed salary reduction amount under Section 125 (increasing the carryover amount to $660 in 2025, $640 in 2024, $610 for 2023).⁵ This change, while enacted in the wake of the COVID-19 pandemic, is permanent.

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Planning Point: The IRS has released guidance clarifying application of the carryover provision. The IRS guidance has made clear that, unlike health savings accounts (HSAs) or health reimbursement arrangements (HRAs), the FSA cannot allow the participant to accumulate funds from year to year. The carryover applies only to the single year that immediately follows the year of contribution.⁶

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The plan may reimburse medical expenses of the kind described under IRC Section 213(d), but may not reimburse for premiums paid for other health plan coverage.⁷

Editor’s Note: Under current law, the plan can reimburse for nonprescription over- the-counter drugs.⁸ However, for taxable years beginning after December 31, 2010 and before March 2020, reimbursements for medicine were limited to doctor-prescribed drugs and insulin. That requirement was repealed by the 2020 CARES Act in the wake of the COVID-19 pandemic.⁹

The medical expenses must be for medical care provided during the period of coverage with substantiation that the expense claimed has been incurred and is not reimbursable under other health coverage.¹⁰

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Planning Point: Employees should remember that health expenses are deemed to be “incurred” when the service is actually provided--not when the employee is billed.

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The IRS has approved the use of employer-issued debit and credit cards to pay for medical expenses as incurred, provided that the employer requires subsequent substantiation of the expenses or has in place sufficient procedures to substantiate the payments at the time of purchase.¹¹ On a one-time basis, a plan may allow a qualified HSA distribution. See Q 413.

Employer-provided coverage for qualified long-term care services provided through an FSA is included in the employee’s gross income.¹²

Informal IRS Guidance on FSAs. In August of 2001, the IRS provided informal, nonbinding guidance regarding FSAs. In a departure from previous informal guidance, the IRS indicated that orthodontia expenses should be treated differently from other medical expenses. Under this reasoning, if orthodontia expenses are paid in a lump sum when treatment commences, rather than over the course of treatment, they could be reimbursed under an FSA when paid. Finally, the IRS informally clarified that there is no de minimis claim amount that need not be substantiated; employers and plan administrators may not disregard the substantiation requirements for small claims.