Napier & Company, LCC

Recently the IRS announced that employers who have cafeteria plans may elect to modify the plan document to change the rule that says that the employees must use all of their funds by the end of the plan year, or lose the funds. The new rules allows for a 2-1/2 month grace period. In other words, participants with a balance remaining at the end of the plan year will be able to use their funds for qualifying expenses that are incurred during a 2-1/2 month grace period following the end of the plan year.

Background

Cafeteria plans (also known as flexible benefit plans or flexible benefit arrangements) allow employees to pay for qualified benefits on a tax advantaged basis using pre-tax dollars. Qualified benefits may include the following:

• Employer-provided accident and health plans
• Group-term life insurance 
• Dependent care assistance programs 
• Adoption assistance programs

Making the Election

IRS Notice 2005-42 permits, but does not require, an employer to amend its plan document to give all participants a grace period lasting no longer than 2-1/2 months immediately following the end of each plan year. Qualified expenses incurred during the grace period may be paid from contributions remaining unused at the end of the plan year.

During the grace period, unused contributions can not be cashed-out or converted to any other taxable or nontaxable benefit. Unused amounts relating to a particular qualified benefit may only be used to pay or reimburse expenses incurred for that particular qualified benefit. For example, unused amounts in a health flexible spending arrangement can't be used to pay or reimburse dependent care or other expenses incurred during the grace period.

Notice 2005-42 says that 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.