Q&A: How Should We Handle Unspent FSA Balances?

Question:

One of our employees had a significant amount of money left in his Health Flexible Savings Account (FSA) at the end of the 2024 plan year. We have encouraged him to submit as many claims as possible before the end of our grace period to avoid forfeiting so much money.

Unfortunately, it looks like he will still have a large unused balance when the grace period runs out. If that happens, our leadership would like to just reimburse him outside the plan. Is that allowed? 

If not, what do we do with the unspent FSA money that this employee – and others with smaller balances – have to forfeit?

Answer:

As you know, your Health FSA allows employees to reduce their taxable income by contributing pre-tax to an account that they can later use to pay for qualified medical expenses. While FSAs are a great opportunity to save on taxes, the situation you are describing is one of their biggest potential downsides for employees.

Once they have decided how much to contribute to their FSA, they are required to either “use it or lose it” by the end of the plan year. This is a well-established principle under IRS regulations, although there are limited exceptions.

While it is understandable to want to make the employee whole, I recommend that you first:

• Determine whether you have a “runout period” in addition to a grace period. These two concepts are easy to confuse. FSAs may have one, both, or neither.
  • A grace period allows employees to incur new medical expenses and use their FSA to pay for them. It typically runs for 2.5 months after the end of the plan year.
  • A runout period lasts longer than a grace period and gives employees more time to submit expenses that were incurred during the claim year and/or grace period.
• If the employee is completely out of time to submit claims, then you must decide whether to try to reimburse him outside the plan. IRS regulations are clear that balances that remained unused at the end of the plan year/grace period/runout period cannot be returned to employees. If your leaders are unhappy with this, I recommend they consult an attorney for additional advice.

As for your question about what to do with amounts forfeited by employees, you could:

• Use them to defray the costs of plan administration (the most common approach),
• Cut salary reduction amounts for employees on a reasonable and uniform basis,
• Increase the account balances of all participants (also on a reasonable and uniform basis); or
• Return funds to all employees who participated in the FSA in the form of cash.

In addition, if you are a governmental or church plan that is exempt from ERISA, you may have the option of retaining the funds.