Cafeteria Plans Become More Flexible

July 29, 2005

Cafeterias that serve food are but a distant memory in most communities. However, cafeteria plans that provide employee fringe benefits are still very much alive and well. Most large employers have them and many small employers do as well.

A cafeteria plan allows employees to elect among cash and one or more tax-free qualified benefits. These benefits can include accident and health plans, group-term life insurance, dependent care assistance programs, adoption assistance programs, and health and dependent care flexible spending accounts (FSAs). Once made, an employee’s cafeteria plan elections for the year can be changed only in accordance with Reg. 1.125-4 (which normally requires a change in life circumstances).

Because cafeteria plans aren’t allowed to provide employees with deferred compensation [IRC Sec. 125(d)(2)(A)], a significant disadvantage of such a plan (particularly with health care and dependent care FSAs) is the so called “use-it-or-lose-it” provision. Thus, for example, an employee who elects to put $2,000 of their pretax compensation into their health FSA for the year but only has $1,500 of qualifying expenses would forfeit the other $500.

This fear of loosing part of their own money is one of the primary reasons more employees don’t take advantage of cafeteria plan FSAs. As a result, the IRS has recently been prodded by certain members of Congress to modify the use-it-or-lose-it rule without the need for congressional action. Although the IRS doesn’t believe it has the authority to do this, it has come up with what may be the next best thing.

New Short-term Deferral Option

Effective for the current plan year, IRS Notice 2005-42 gives employers the option of amending their cafeteria plans to provide for a grace period immediately following the end of the plan year. The advantage of the grace period, which must apply to all participants in the plan, is that 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.

Example 1: Acme Corp. has a calendar-year cafeteria plan. Prior to the end of 2005, it amends the plan to permit a grace period that 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 the plan year.

The grace period may not go beyond the 15th day of the 3rd month after the end of the plan year to which it relates (i.e., the standard 2½ month rule that traditionally applies to deferred compensation). If a cafeteria plan is amended to include a grace period, a participant with unused contributions from the preceding year, who incurs expenses for that same qualified benefit during the grace period, can be reimbursed for those expenses as if the expenses had occurred in the preceding plan year.

Example 2: Assume the same facts as in Example 1 and that Acme selected a 2½ month grace period for its plan. ?xml:namespace prefix = st1 ns = “urn:schemas-microsoft-com:office:smarttags” /Tyler participates in Acme’s plan and has a health FSA. He timely elected a salary reduction of $2,000 for his health FSA for the plan year ending 12/31/05.

At the end of 2005, Tyler has $300 remaining in his account. Also, he timely elects a 2006 salary reduction of $1,500.

During the grace period from 1/1/06–3/15/06, Tyler incurs $400 of unreimbursed qualified medical expenses. The unused $300 from the 2005 plan year is first applied to reimburse him for $300 of the medical expenses incurred during the grace period. Thus, as of 3/16/06, he has no unused benefits remaining from 2005. The other $100 of expenses incurred in the grace period can be paid from the funds Tyler puts in his Health FSA for the 2006 plan year (leaving him a balance of $1,400 available for reimbursement during the rest of 2006 or the first 2½ months of 2007).

A cafeteria plan can’t permit unused benefits or contributions to be cashed-out or converted to any other taxable or nontaxable benefit during the grace period. In addition, unused benefits or contributions relating to a particular qualified benefit can only be used to pay or reimburse expenses incurred with respect to that particular qualified benefit.

Example 3: Assume the same facts as in Examples 1 and 2 and that Tara participates in both Acme’s health FSA plan and its dependent care FSA plan. For 2005, she elected a salary reduction of $1,000 for the health FSA and $3,000 for the dependent care FSA plan. Through the end of the year, she incurred $1,100 of unreimbursed qualified medical expenses and incurred another $250 during the first 2½ months of 2006. Thus, none of her 2005 deferral of $1,000 for the health FSA was wasted and she has $100 of excess expenses in 2005 and another $250 of excess qualified expenses during the grace period.

For the 14½ months ending 3/16/06, Tara has $2,700 of qualified dependent care expenses. Thus, she has $300 of excess funds. Unfortunately, she can’t use those excess funds to reimburse part of her $350 of excess medical expenses. Instead, to the extent any unused benefits or contributions for a year exceed the expenses for that qualified benefit during the year and any available grace period, those remaining benefits can’t be used for expenses of another type of qualifying benefit. Nor can the excess benefits be carried forward to a subsequent plan year. Instead, they’re forfeited.

Example 4: Assume the same facts as Examples 1 and 2 except that Tyler only incurs $250 of medical expenses during the grace period. At 3/16/06, he has $50 of unused benefits remaining from 2005. The unused $50 can’t be cashed-out, converted to another taxable or nontaxable benefit or used in any other plan year. Instead it is subject to the use-it-or-lose-it rule and is forfeited. On 3/16/06, he has $1,500 available to use in the 2006 FSA plan year.

Observation: As under the current rules, Notice 2005-42 provides that employers can continue to provide a “run-out” period after the end of the grace period. During this period, expenses for qualified benefits incurred during the cafeteria plan year and the grace period may be paid or reimbursed.


Employers can adopt a grace period for the current cafeteria plan year (and subsequent plan years) by amending their plan documents before the end of the current plan year. Thus, this change is something they need to know about now in case they want to implement the grace period for the 2005 plan year.

The attached letter can be used to help get the word out. As a subscriber to this newsletter, you may edit and distribute the letter to clients, potential clients, and referral sources as you see fit. However, please remember that the material is copyrighted. You may not use it for any other purpose, such as posting it on a website area available to the public or sharing it with another firm or association of firms of which you’re a member.


IRC Sec. 125.

IRS Notice 2005-42, 2005-23 IRB.

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