Employers are getting some welcome relief in the form of IRS guidance that provides helpful details and clarity on how to implement the upcoming $2,500 limit on salary reduction contributions to health flexible spending accounts (FSAs) set by the Patient Protection and Affordable Care Act (PPACA).

Notice 2012-40, which was issued by the IRS on May 30, 2012, also provides a generous deadline for amending cafeteria plans to reflect this new limit – before year-end 2014 – and indicates that the Treasury Department and IRS are considering modifying the “use-it-or-lose-it” rule that has long troubled health FSA participants.


The PPACA affects health FSAs in several ways. For example, it adds Internal Revenue Code Section 125(i), which imposes a $2,500 limit on salary reduction contributions to health FSAs effective for “taxable years” beginning after December 31, 2012. The $2,500 limit will be indexed for inflation in future years (beginning December 31, 2013).

The PPACA requirements sometimes overlap with proposed cafeteria plan regulations that the IRS issued in 2007. These proposed regulations contain very explicit and detailed requirements as to what must be included in a written cafeteria plan document. One requirement is to specify the maximum amount of salary reduction contributions that may be made to a health FSA. The proposed regulations generally require plan amendments to be adopted prior to the date when they become effective. The proposed regulations also contain the “use-it-or-lose-it” rule, which generally prohibits contributions under a health FSA from being used in a subsequent plan year or period of coverage. Failure to satisfy these rules would trigger disqualification of the entire arrangement resulting in significant tax consequences. The issuance of final regulations is on the Treasury agenda, and plan sponsors must be aware of the impact they will have on their cafeteria plans and health FSAs.

The $2,500 Limit – Plan Year

The Notice clarifies how the new $2,500 limit will operate. The Notice specifies that the “taxable year” described under the PPACA provision means the plan year for the relevant cafeteria plan. This interpretation is easier for employers to administer than alternatives would have been. The $2,500 limit on health FSA salary reduction contributions will apply on a plan year basis effective with plan years beginning after December 31, 2012.

Operational Issues

The Notice addresses a few operational issues in dealing with the $2,500 limit, all in ways that appear favorable to employers. First, if a plan provides a grace period (i.e., participants in a calendar year health FSA have until March 15th of the following plan year to incur expenses and get reimbursements), unused salary reduction contributions carried over into the next year would not count against the $2,500 limit for that subsequent year.

Second, the Notice provides guidance as to how employer non-elective contributions (i.e., flex credits) are to be accounted for in dealing with the $2,500 limit. If such flex credits must be used for a qualified benefit such as a health FSA, the participant may still elect to make a salary reduction contribution of $2,500. However, if the flex credit may be used for the qualified benefit or cashed out, those flex credits will be treated as a salary reduction contribution and, as a result, will impact the amount of salary reduction contribution that a participant may make.

Third, the Notice provides relief and the opportunity for correction in the event that salary reduction contributions exceed the $2,500 limit, and if it was the result of a reasonable mistake and not due to the employer’s willful neglect.

Request for Comments – Use-It-Or-Lose-It Rule

The IRS specifically requests comments in the Notice on the use-it-or-lose-it rule under the proposed regulations. The IRS and Treasury state that given the new limit, they are considering modification of the use-it-or lose-it rule.


The Notice provided much needed guidance in dealing with the new $2,500 limit for health FSAs. In light of the delayed plan amendment requirement and outstanding final cafeteria plan regulation, plan sponsors may want to consider waiting before taking action with respect to their plan documents. Notwithstanding this plan document consideration, plan sponsors must be ready to comply from an operational perspective in 2013. Because many cafeteria plans are operated on a plan year basis, this will require action in late 2012 to ensure that plan participants are notified of the changes and plan operations are updated accordingly.

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