Cafeteria plans allow participants to choose among two or more benefits consisting of cash and qualified benefits. Qualified benefits include employer-provided accident and health plans, group-term life insurance, dependent care assistance programs and adoption assistance programs.

A cafeteria plan may not include any plan that offers a benefit that defers the receipt of compensation or operates in a manner that enables employees to defer compensation.

• A plan defers the receipt of compensation if it permits employees to carry over unused elective contributions or plan benefits (e.g. accident or health plan coverage) from one plan year to the next.
  
  
• A plan operates to permit the deferral of compensation if the plan permits participants to use contributions for one plan year to purchase a benefit that will be provided in a subsequent plan year.

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."

To be consistent with other areas of tax law, where a grace period of 2½ months is allowed after the end of a taxable year, the Treasury and the IRS believe it is appropriate to modify the current prohibition on deferred compensation to permit a grace period after the end of the plan year during which unused benefits or contributions may be used.

Accordingly, the rule that a cafeteria plan may not defer the receipt of compensation is modified to allow a cafeteria plan document, at the employer's option, to be amended to provide for a grace period immediately following the end of each plan year. The grace period must apply to all participants in the cafeteria plan. Expenses for qualified benefits incurred during the grace period may be paid or reimbursed from benefits or contributions remaining unused at the end of the immediately preceding plan year. The grace period 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").

If a cafeteria plan document is amended to include a grace period, a participant who

• has unused benefits or contributions relating to a particular qualified benefit from the immediately preceding plan year, and
  
  
• incurs expenses for that same qualified benefit during the grace period,

may be paid or reimbursed for those expenses from the unused benefits or contributions as if the expenses had been incurred in the immediately preceding plan year.

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 before those amounts are "forfeited" under the "use-it-or-lose-it" rule.

During the grace period, a cafeteria plan may not permit unused benefits or contributions to be cashed-out or converted to any other taxable or nontaxable benefit. Unused benefits or contributions relating to a particular qualified benefit may only be used to pay or reimburse expenses incurred with respect to that particular qualified benefit. For example, unused amounts elected to pay or reimburse medical expenses in a health flexible spending arrangement (FSA) may not be used to pay or reimburse dependent care or other expenses incurred during the grace period. To the extent any unused benefits or contributions from the immediately preceding plan year exceed the expenses for the qualified benefit incurred during the grace period, those remaining unused benefits or contributions may not be carried forward to any subsequent period (including any subsequent plan year) and are "forfeited" under the "use-it-or-lose-it" rule.

As under current practice, employers may continue to provide a "run-out" period after the end of the grace period, during which expenses for qualified benefits incurred during the cafeteria plan year and the grace period may be paid or reimbursed.

An employer may adopt a grace period as authorized in this notice for the current cafeteria plan year (and subsequent cafeteria plan years) by amending the cafeteria plan document before the end of the current plan year.

These new rules are illustrated by the two situations described in the following example:

Example: An employer with a cafeteria plan year ending on December 31, 2005, amends the plan document before the end of the plan year to permit a grace period which allows all participants to apply unused benefits or contributions remaining at the end of the plan year to qualified benefits incurred during the grace period immediately following that plan year. The grace period ends on March 15, 2006.

An employee elects a salary reduction of $1,000 for a health FSA for the plan year ending December 31, 2005. At the end of that plan year, $200 remains unused in the health FSA. The employee elects a reduction for a health FSA of $1,500 for the plan year ending December 31, 2006.

Situation 1: During the grace period from January 1 through March 15, 2006, the employee incurs $300 of un-reimbursed medical expenses.

• The unused $200 from the plan year ending December 31, 2005 is applied to pay or reimburse $200 of the $300 of medical expenses. Therefore, as of March 16, 2006, X has no unused benefits or contributions remaining for that plan year.
  
  
• The remaining $100 of medical expenses incurred between January 1 and March 15, 2006 is paid or reimbursed for the plan year ending December 31, 2006. Therefore, as of March 16, 2006, $1,400 remains in the health FSA for the new plan year.

Situation 2: During the grace period from January 1 through March 15, 2006, the employee incurs $150 of un-reimbursed medical expenses.

• $150 from the plan year ending December 31, 2005 is applied to pay or reimburse the $150 of medical expenses incurred during the grace period. Therefore, as of March 16, 2006, there is $50 of unused benefits or contributions remaining for that plan year. The unused $50 cannot be cashed-out, converted to any other taxable or nontaxable benefit, or used in any subsequent plan year. It is subject to the "use-it-or-lose-it" rule and is "forfeited."
  
  
• As of March 16, 2006, the employee has the entire $1,500 elected in the health FSA for the new plan year.

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...back to 19 May 2005

Further information:
Modification of Application of Rule Prohibiting Deferred Compensation Under a Cafeteria Plan