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IRS Modifies 'Use-It-Or-Lose-It' Rule For Section 125 Cafeteria Plans
The Internal Revenue Service has modified the rule prohibiting deferred compensation under a Section 125 cafeteria plan to allow a grace period of up to 2.5 months after the end of the plan year to use the benefits or contributions before those amounts are forfeited under the “use-it-or-lose-it” rule. Notice 2005-42, 2005-23 I.R.B. 1 (May 18, 2005) (the Notice) permits a 2.5- month grace period during which additional expenses can be incurred and which will be reimbursed from contributions made in the plan year preceding the grace period. An employer may adopt a grace period for the current cafeteria plan year by amending the plan before the end of the current plan year.
Implications
The 2.5-month grace period relaxes the restrictive rule for health flexible spending arrangements (FSAs) and dependent care assistance programs that any funds that were not spent by the end of the plan year would be forfeited. By permitting participants to use contributions for 1 plan year to purchase a benefit that is provided during the first 2.5 months in a subsequent plan year, the new rule will ease the year-end spending rush and provide an incentive for employees to participate in health FSAs. 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. It should be noted that cafeteria plans with a June 30 plan year end must be amended by June 30, 2005, in order for the grace period to be effective for the current plan year.
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