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IRS considers modifying FSA 'use it or lose it rule

I’m perpetually shocked at the high percentage of Americans who forgo enrollment in flexible spending accounts (FSAs). Given how these accounts are exclusively designed to save you up to 40 percent on your out-of-pocket health care expenses, why wouldn’t you want to sign up and keep more of the money you earn? 

While I’ve received a variety of responses to this question, the top barrier cited is the dreaded “use it or lose it” provision, which forces participants to forfeit or quickly spend up any unused money in their FSA at the end of the plan year. In response, I always suggest new participants ease into the program and only set aside a small amount to cover their known out-of-pocket health expenses, but I’m getting off topic.

There’s a chance the FSA “use it or lose it” rule could be a thing of the past. 

Currently, the IRS is soliciting comments on modifying the forfeiture rule. It’s too early to tell whether this request for comments will result in a rule change. However, I am certain a rule change would be a game changer with two important results. First, participants would no longer rush to spend unused dollars at year end, which can result in wasteful health care spending. Second, more consumers would sign up for these accounts – a win not only for participants who need access to dollars for out-of-pocket health care expenditures, but employers in the form of reduced payroll taxes.

Already, comments are pouring into the IRS, arguing why the rule needs to be changed. A common argument is that the rule forces account holders to try and predict their unpredictable health expenses a year in advance, and then penalizes them if their account contributions and health care expenditures don’t exactly align. One submission argued, “Who can estimate when a catastrophic illness will take place, additional medicine will need to be prescribed, or a pregnancy or accident will occur?”  The answer, of course, is no one.  

There’s also the argument about how the IRS originally adopted the “use it or lose it” rule to prevent FSAs from being misused as tax shelters, which no longer applies now that the Affordable Care Act caps annual FSA contributions at $2,500 beginning in 2013. 

The next big question is how the forfeiture rule should be modified.

While various options are being considered, I’m supportive of allowing participants to roll over their unused funds into the next plan year. The funds would still be available only for eligible health care expenses, so they shouldn’t result in deferred compensation.

As much as I’m supportive of this change, I recognize there are some who are concerned about a greater exposure due to the end of the forfeiture rule and ability to capture funds to offset employees who spend up their account funds and leave before the end of the plan year. The reality, based on experience from more than 2 million participants, is that this rarely happens. While this is a legitimate concern, especially for smaller employers, I’m confident modifying “use it or lose it” would eliminate the key barrier for many potential FSA users and the increased enrollment will offset any prospective losses as a result of the uniform coverage rule. 

If you’re interested in submitting your own comments to the IRS, you have until Aug. 17 to do so. Simply send your comment to [email protected] and include “Notice 2012 – 40” in the subject line.

I hope you join me in keeping your fingers crossed that the IRS moves to change the burdensome and ill-conceived “use it or lose it” rule.