8901 / What are the tax benefits that can be realized by providing employee benefits through a cafeteria plan?

As a general rule, a participant in a cafeteria plan is not treated as being in constructive receipt of taxable income solely because he or she has the opportunity – before a cash benefit becomes available – to elect among cash and “qualified” benefits (generally, nontaxable benefits).¹
A participant must elect the qualified benefits before the cash benefit becomes currently available in order to avoid taxation. That is, the election must be made before the specified period for which the benefit will be provided begins—generally, the plan year.²A cafeteria plan may, but is not required to, provide default elections for one or more qualified benefits for new employees or for current employees who fail to timely elect between permitted taxable and qualified benefits.³Benefits provided under a cafeteria plan through employer contributions to a health flexible spending arrangement (FSA) are not treated as qualified unless the plan provides that an employee may not elect to have salary reduction contributions in excess of $2,500 (this amount is indexed annually for inflation, see Q 8902) made to the FSA for any tax year.⁴ Under IRS Notice 2012-40:

(1)  the $2,500 contribution limit did not apply for plan years that begin before 2013;

(2)  the term “taxable year” in IRC Section 125(i) refers to the plan year of the cafeteria plan, as this is the period for which salary reduction elections are made;

(3)  plans could adopt the required amendments to reflect the contribution limit at any time through the end of calendar year 2014;

(4)  in the case of a plan providing a grace period (which may be up to two months and 15 days), unused salary reduction contributions to the health FSA for plan years beginning in 2012 or later that are carried over into the grace period for that plan year will not count against the contribution limit for the subsequent plan year; and

(5)  unless a plan’s benefits are under examination by the IRS, relief is provided for certain salary reduction contributions exceeding the contribution limit that are due to a reasonable mistake and not willful neglect, and that are corrected by the employer.

Under IRS Notice 2013-71, heath FSAs may now be amended so that $500 ($660 in 2025, $640 in 2024; $610 in 2023 and $570 in 2022) of unused amounts remaining at the end of the plan year may be carried forward to the next plan year. However, plans that incorporate the carry forward provision may not also offer the grace period that would otherwise allow FSA participants an additional period after the end of the plan year to exhaust account funds.⁵

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1.  IRC § 125; Prop. Treas. Reg. § 1.125-1.