Use-It-or-Lose-It Rule

The use-it-or-lose-it rule is the principle that contributions and benefits remaining in a flexible spending account at the end of the plan year are forfeited to the employer rather than carried forward or refunded. It is the best-known feature of these accounts and the least well explained, because it is usually described as an arbitrary employer-friendly design when it is actually the byproduct of a statutory prohibition.

The prohibition is in Internal Revenue Code section 125(d)(2)(A), which provides that the term "cafeteria plan" does not include any plan that provides for deferred compensation. Notice 2013-71 traces the chain in one sentence: "Pursuant to sec. 125(d)(2)(A), a sec. 125 cafeteria plan generally does not include any plan that provides for deferred compensation. Proposed regulations under sec. 125 that predated the enactment of the Act generally have prohibited participants from using contributions made for one plan year to purchase a benefit that will be provided in a subsequent plan year. Commonly referred to as the 'use-or-lose' rule, this requires that unused benefits or contributions remaining as of the end of the plan year ... be forfeited." Letting an employee roll money forward would be exactly the deferral the statute bars, so forfeiture is what keeps the arrangement a cafeteria plan at all.

Two features of that chain are worth holding on to. The rule reaches the whole cafeteria plan rather than health flexible spending accounts specifically, because the statutory ban is written at the plan level. And the regulations doing the work are proposed rather than final ones: Notice 2013-71 cites Prop. Treas. Reg. sections 1.125-1 and 1.125-5 throughout, says Treasury and the IRS "intend to amend" them to reflect the notice, and tells taxpayers they "may rely on the guidance in this notice pending the issuance and effectiveness of those amendments to the regulations." That is unusual, and it is why the rule is described in notices and publications rather than quoted from a final regulation.

The naming, since both versions are the IRS's own. Publication 969 says "FSAs are generally 'use-it-or-lose-it' plans. This means that amounts in the account at the end of the plan year can't generally be carried over to the next year." Notice 2005-42 says the same: "This rule is commonly referred to as the 'use-it-or-lose-it' rule, requiring that unused contributions or benefits remaining at the end of the plan year be 'forfeited.'" Notice 2013-71 uses the shorter form, in its own title and throughout. Neither spelling is a statutory term. Both notices flag it as the common name for a proposition whose actual legal source is the deferred-compensation ban, which is why no search of the Code for either phrase finds anything.

Run-out period versus grace period, which is where the money is actually lost. These two are routinely treated as the same thing and they do opposite work. Notice 2013-71 defines them side by side. A run-out period "is a period immediately following the end of a plan year during which a participant can submit a claim for reimbursement of expenses incurred for qualified benefits during the plan year." It then continues: "By contrast, a grace period is a period of up to two months and 15 days immediately following the end of a plan year during which a participant may use amounts remaining from the previous plan year ... to pay expenses incurred for certain qualified benefits during that two-month-and-15-day period."

So a run-out period is a paperwork window: it extends how long you have to file a claim, and the expense must already have happened inside the plan year. A grace period is a spending window: it extends the period in which you can incur new eligible expenses. An employee with unspent money on December 31 and a run-out period through March has no way to use it, because nothing they buy in January qualifies. The same employee with a grace period does. The two are also different in kind rather than in degree. A run-out period is a claims-processing window that a plan year assumes: Notice 2013-71 measures the unused balance itself "at the end of the plan's run-out period for the plan year." A grace period is one of the two reliefs an employer may elect, and a plan may offer neither.

Where the calendar arithmetic comes from. Notice 2005-42 created the grace period and set its outer edge: it "must not extend beyond the fifteenth day of the third calendar month after the end of the immediately preceding plan year to which it relates (i.e., 'the 2 and 1/2 month rule')." The notice then states the consequence in the form employees actually need: "The effect of the grace period is that the participant may have as long as 14 months and 15 days (the 12 months in the current cafeteria plan year plus the grace period) to use the benefits or contributions for a plan year." For a calendar-year plan that is March 15.

Leaving the job forfeits the balance, and there is one exit. Notice 2013-71 states that "any unused amount remaining in an employee's health FSA as of termination of employment also is forfeited (unless, if applicable, the employee elects COBRA continuation coverage with respect to the health FSA)." A health flexible spending account is a group health plan for those purposes, so continuation coverage can be available, paid for with after-tax money, and it is the only route by which a departing employee reaches a balance they have not yet claimed against.

Nothing converts to cash, ever. Notice 2013-71 is explicit: "A sec. 125 cafeteria plan is not permitted to allow unused amounts relating to a health FSA to be cashed out or converted to any other taxable or nontaxable benefit." Publication 969 says the same about the grace period, that the employer "isn't permitted to refund any part of the balance to you." An employer offering to pay out a leftover balance would be operating the plan outside section 125, and the consequence would fall on every participant's exclusion rather than on the one who was paid.

A carryover does not eat next year's election. Where a plan offers the carryover relief, Notice 2013-71 confirms that the amount carried forward "does not count against or otherwise affect the indexed ... salary reduction limit applicable to each plan year." So a participant can carry forward the permitted amount and still elect the full limit for the new year. The carryover cap is $680 and the salary reduction limit is $3,400, and the point here is that they do not interact.

1. The employee elects an annual amount before the plan year begins, and it is withheld from pay before tax across the year.

2. Claims are reimbursed as eligible expenses are incurred, against the election rather than against what has been withheld so far.

3. The plan year ends. Whatever is unspent is forfeited, unless the plan offers one of the two reliefs an employer may elect.

4. A run-out period, if the plan has one, keeps the claims window open for expenses already incurred inside the plan year. It does not extend the spending window.

5. Termination of employment forfeits the balance, unless continuation coverage is elected for the account.

A hypothetical, showing the run-out and grace distinction. Marisol's plan year ends December 31. On that date $310 of her election is unspent. Her plan has a run-out period through March 31 and no grace period.

A dental visit on December 18 that she has not yet claimed is reimbursable: the expense was incurred inside the plan year, and the run-out period is what gives her until March 31 to submit it. A new pair of glasses bought on January 20 is not, because the run-out period governs when she may file, not when she may spend. The $310 is lost.

Had her employer also elected a grace period, the outer limit would be the fifteenth day of the third calendar month after the plan year, which is March 15, and the January 20 glasses would be reimbursable from the prior year's money. Counting from the start of the plan year, that is the 14 months and 15 days Notice 2005-42 describes. An employer may offer one relief or the other, and offering a grace period is a choice rather than a right.

Pros

• The forfeiture is the counterweight to a rule that runs strongly in the employee's favor: the entire annual election is available from the first day of the plan year, and an employee who leaves mid-year is not asked to repay the difference.
• Because the rule is statutory rather than discretionary, an employer cannot apply it selectively or negotiate it away for some employees.
• Understanding it converts an unpleasant surprise into a planning decision at open enrollment, which is the only point at which it can be managed.
• Where an employer elects a relief, the carryover does not reduce the following year's salary reduction limit.

Cons

• Money genuinely disappears at the end of the plan year, and what is lost is the employee's own pay, withheld and never spent.
• The run-out period is widely mistaken for extra time to spend, which is how a balance that looked safe is lost.
• Leaving a job forfeits the balance unless continuation coverage is elected and paid for with after-tax money.
• There is no cash-out and no refund at any point, however small the balance.
• The reliefs are the employer's to offer, and a plan may offer neither.
• Estimating a year of medical spending in advance is genuinely hard, and the rule puts the entire cost of guessing high on the employee.