FSA Salary Reduction Capped at $2,500, Starting January 2013

Changes are coming to flexible spending accounts. Under the Patient Protection and Affordable Care Act (PPACA), a new $2,500 limit will be imposed on salary reduction contributions to health flexible spending arrangements, commonly known as FSAs.
FSAs are popular perks that allow employees to divert income on a pre-tax basis to an account that they can use to buy certain eligible health care services.  They are particularly useful for employees who have regular health expenses that they incur each year that meet the eligibility criteria, since the FSA allows them to buy these needed health services with pre-tax dollars.

Under current law, salary deferral contributions to these arrangements were unlimited by the tax code. Employers had the discretion to set caps wherever they wanted. The new $2,500 limit applies to all FSA plan years beginning after December 31, 2012. Congress currently intends to adjust the cap each year along with the cost of living, beginning with plan years beginning in 2014. The cap is one-size-fits all, no matter how many dependents you have.

The salary reduction/ election cap only applies to salary reduction contributions to health FSAs. It does not apply to the employer’s contributions, nor does it apply to health reimbursement arrangements (HRAs), health savings accounts (HSAs), child or dependent care assistance programs, etc. The cap is specific to health flexible savings arrangements (health FSAs).
Earlier this month, the Internal Revenue Service issued a clarification on how the new caps will affect existing plans. Notice 2012-40 establishes that the new caps don’t apply on plan years beginning this year or last year.

If your plan has a grace period, salary contributions that aren’t spent during the formal plan year don’t count against the next years’ contributions, according to the notice. The cap only applies to new contributions, not remaining balances from plan year 2012. However, the ‘use it or lose it’ provision of FSAs still applies – balances left unused after the employer-designated grace period, which can last up to two and a half months after the end of the plan year, are forfeited.

What happens if an accidental contribution occurs?

The IRS also assured employers that if an employer accidentally allowed a contribution greater than $2,500 in a new plan year, in violation of the cap, it would not necessarily result in the IRS disqualifying an entire Section 125 plan. Employers just have to pay the excess back to the employee and include the overage in the employee’s taxable income for the year.
If the plan year is less than 12 months, the $2,500 cap is prorated accordingly.

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