The Affordable Care Act health care reform law limits employees’ pretax contributions into health flexible spending accounts (FSAs) to $2,500 for taxable years beginning after Dec. 31, 2012. Problem: It wasn’t clear whose taxable year counted—the employee’s, the employer’s or the cafeteria plan’s.
According to IRS guidance, the $2,500 limit applies to plan years beginning after Dec. 31, 2012 (i.e., Jan. 1, 2013, for calendar-year plans). The IRS is also providing relief to plans that inadvertently allow employees to defer more than $2,500. The guidance is effective for plan years beginning after Dec. 31, 2012. Indexing of the $2,500 limit applies to plan years beginning after Dec. 31, 2013. (Notice 2012-40, IRB 2012-25)
What’s on the menu. The $2,500 pretax limit applies per employee, regardless of the number of dependents the employee covers through the health plan. Breaks: Since the limit applies on a per-employee basis, spouses who work for the same employer can each defer up to $2,500 into their own FSAs. Employees who work for two unrelated employers can defer up to $2,500 to multiple FSAs.
The $2,500 limit doesn’t apply to employer flex credits (but flex credits may need to be reported on employees’ W-2s). Nor does it apply to amounts that employees can carry over into the next plan year under a cafeteria plan’s grace period provision.
Cafeteria plans must be amended to conform to the $2,500 pretax limit. As long as the amendment is adopted before Dec. 31, 2014, it may be made effective retroactively. Proviso: The cafeteria plan must still implement the $2,500 limit for plan years beginning after Dec. 31, 2012.
Warning: Cafeteria plans that fail to comply with the $2,500 limit for plan years beginning after Dec. 31, 2012, will forfeit their tax-qualified status. Upshot: All benefits—even tax-free benefits—become taxable and subject to withholding.
Note: Withholding applies. Employees who inadvertently defer more than $2,500 won’t jeopardize the tax-qualified status of the cafeteria plan if the error resulted from a reasonable mistake and the excess deferral is returned to the employee and taxed as wages. However, this relief isn’t available to plans or employers that are under audit.
Tip: The indexing of the pretax limit and the fact that withholding applies to excess deferrals means that you need to have a clear communication line open with the benefits department.
Note: The IRS is rethinking whether health FSA’s use-it-or-lose-it rule should be modified, given the $2,500 pretax limit. It wants to know what you think. Comments must be submitted by Aug. 17, 2012. Email comments to Notice.firstname.lastname@example.org. Be sure you include Notice 2012-40 in the subject line of your email. Remember: Be nice! All comments will be open for public inspection and copying.