Under the health plan flexible spending account (FSA) rules, all FSA amounts must be used for reimbursement within the plan year and grace period (subject to a plan's carryover rules). Amounts not used are "forfeited." Forfeitures, the amounts remaining in participants’ accounts that are not used to pay eligible expenses incurred during the plan year, are returned to the employer under the IRS “use it or lose it” rule.
The use of forfeitures is governed by both ERISA (for an ERISA-covered plan) and the Internal Revenue Code. ERISA’s “exclusive benefit” rule provides that the assets of a plan shall never insure to the benefit of any employer and shall be held for the exclusive purposes of providing benefits to participants in the plan and their beneficiaries and defraying reasonable expenses of administering the plan.
An employer generally has 4 options for using forfeitures. Forfeitures may be (1) used to defray plan administration expenses; (2) used to reduce salary reduction amounts for the following year; (3) used to increase the annual coverage amount; or (4) returned to employees in the form of cash.
- Use forfeitures to defray plan administration expenses. Most employers use as much of the forfeiture as possible to defray plan administration expenses. This is the easiest option to administer, as it is usually just a bookkeeping entry. Administration expenses include the expenses the plan incurs from a third party administrator for FSA claims administration. The employer does have to be careful to use the expenses only for the health FSA (and not for expenses of a dependent care FSA, if there is one). Guidance indicates that the forfeitures may be used for administration expenses for any plan year.
- Use forfeitures to reduce salary reduction amounts for following year. Out of the possible options for allocating forfeitures to employees, reducing salary reduction amounts (sometimes called a “premium holiday”) is usually one the employer likes the best. This must be done on a uniform basis and for the immediately following plan year. As an example, a $200 health FSA for the next plan year may only cost $180. While it is not completely clear about who gets the premium holiday, there is an example in the IRS regulations in which the only employees who are eligible for the reduced salary reduction contributions are those who participated in the plan during the previous year when the forfeiture occurred.
- Use forfeitures to increase the coverage amount. This option would involve the employer allocating the forfeiture on a uniform basis to participants to increase the maximum contribution amount. Since the amount would be an employer, not an employee contribution, the Health FSA limit could effectively go over the maximum ($2,650 for 2018).
- Return the forfeitures to employees in the form of cash. This option requires that the amounts be returned to employees on a reasonable and uniform basis. Many employers do not like using this option. The guidance is not clear on if the cash refunds should be made only to those who had salary reductions during the year in which the forfeitures arose or if the refunds should be distributed to all FSA participants in the year in which the forfeitures are allocated. The guidance is also not clear about whether former employees must receive a refund, although it seems to be the prevailing guidance. Cash returned to employees from FSA forfeitures will be considered W-2 wages to the employee, which also raises issues for payments to former employee FSA participants.
Because of the ambiguity in the allocation of cash refunds, many employers try very hard to allocate forfeitures to reduce administration expenses.
