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Many employers offer popular pre-tax benefits such as health insurance premiums, health FSAs, and dependent care FSAs, assuming that running deductions through payroll on a pre-tax basis is enough. However, one critical component to offering these plans that is often overlooked is that these benefits generally must be offered pursuant to a written Section 125 plan. Often discovered during an audit or transaction, the failure to maintain a written plan document can expose employers to unexpected tax penalties.
A Section 125 plan, commonly referred to as a cafeteria plan or Premium Only Plan (POP), provides employees with the option of purchasing employer-sponsored benefits on a pre-tax basis. These plans allow employees to pick between increased total compensation and contributing part of their compensation towards the payment of benefit premiums. Employees that choose to contribute part of their salary to premiums can do so by making an election. These elections are generally irrevocable during the plan year and a new election cannot be made until the next annual open enrollment period.
Pre-tax salary reductions are only permitted if they are made under a written cafeteria plan. If no written plan exists, or if the document is outdated or inconsistent with actual operations, the IRS may treat all employee contributions as taxable income. A common misconception is that payroll practices or other enrollment materials can substitute for a written plan, however, SPDs, benefit summaries, or other insurance carrier certificates do not replace a Section 125 plan document. The plan must be formally adopted and should clearly spell out:
Offering pre-tax benefits is a valuable tool for both employers and employees, but only when done correctly. We frequently find that employers are not properly handling their pre-tax salary reductions for their benefit plans. Taking the time to confirm a written plan document is in place, up to date, and properly administered can help avoid unnecessary tax penalties. If you have questions or need assistance reviewing your current plan documents, please let us know.
The IRS has released the 2022 contribution limits for FSA and several other benefits in Revenue Procedure 2021-45. The limits are effective for plan years that begin on or after January 1, 2022.
This week the IRS released two new sets of rules impacting Section 125 Cafeteria Plans. Notice 2020-33 provides permanent rule changes that include an increase in the amount of unused benefits that Health FSA plans may allow plan participants to rollover from one plan year to the next. Notice 2020-29 provides temporary rules designed to improve employer sponsored group health benefits for eligible employees in response to the coronavirus pandemic. The relief provided under each notice is optional for employers. Employers who choose to take advantage of any of the offered plan options will be required to notify eligible employees and will eventually be required to execute written plan amendments.
Notice 2020-33 modifies the amount of annual rollover of unused benefits that Health FSA plans may offer to Plan participants. Up until now, rollovers have been limited to $500 per Plan Year. The new rule sets the annual rollover limit to 20% of the statutory maximum annual employee Health FSA contribution for the applicable Plan Year. Because the statutory maximum is indexed for inflation, most years it increases (in mandated increments of $50).
The notice provides that the increased rollover amount may apply to Plan Years beginning on or after January 1, 2020. Because the corresponding annual Health FSA employee contribution limit for those Plan Years is $2,750, the annual rollover limit may be increased up to $550.
The relief provided under Notice 2020-29 falls into two major categories, both of which apply only for calendar year 2020. First, the IRS introduces several significant exceptions to the mid-year change of election rules generally applicable to Section 125 Cafeteria Plans. Second, the notice contains a special grace period which offers Health Flexible Spending Arrangement (FSA) and Dependent Care Assistance Program (DCAP) Participants additional time to incur eligible expenses during 2020.
The temporary exceptions to mid-year participant election change rules for 2020 authorize employers to allow employees who are eligible to participate in a Section 125 Cafeteria Plan to:
None of the above described election changes require compliance with the consistency rules which typically apply for mid-year Section 125 Cafeteria Plan election changes. They also do not require a specific impact from the coronavirus pandemic for the employee.
Employers have the ability to limit election changes that would otherwise be permissible under the exceptions permitted by Notice 2020-29 so long as the limitations comply with the Section 125 non-discrimination rules. For allowable Health FSA or DCAP election changes, employers may limit the amount of any election reduction to the amount previously reimbursed by the plan. Interestingly, even though new elections to make Health FSA and DCAP contributions may not be retroactive, Notice 2020-29 provides that amounts contributed to a Health FSA after a revised mid-year election may be used for any medical expense incurred during the first Plan Year that begins on or after January 1, 2020.
For the election change described in item 3 above, the enrolled employee must make a written attestation that any coverage being dropped is being immediately replaced for the applicable individual. Employers are allowed to rely on the employee’s written attestation without further documentation unless the employer has actual knowledge that the attestation is false.
The special grace period introduced in Notice 2020-29 allows all Health FSAs and DCAPs with a grace period or Plan Year ending during calendar year 2020 to allow otherwise eligible expenses to be incurred by Plan Participants until as late as December 31, 2020. This temporary change will provide relief to non-calendar year based plans. Calendar year Health FSA plans that offer rollovers of unused benefits will not benefit from this change.
The notice does clarify that this special grace period is permitted for non-calendar year Health FSA plans even if the plan provides rollover of unused benefits. Previous guidance had prohibited Health FSA plans from offering both grace periods and rollovers but Notice 2020-29 provides a limited exception to that rule.
The notice raises one issue for employers to consider before amending their plan to offer the special grace period. The special grace period will adversely affect the HSA contribution eligibility of individuals with unused Health FSA benefits at the end of the standard grace period or Plan Year for which a special grace period is offered. This will be of particular importance for employers with employees who may be transitioning into a HDHP group health plan for the first time at open enrollment.
As mentioned above, employers wishing to incorporate any of the allowable changes offered under Notices 2020-29 and 2020-33 will be required to execute written amendments to their Plan Documents and the changes should be reflected in the Plan’s Summary Plan Description and/or a Summary of Material Modification. Notice 2020-29 requires that any such Plan Amendment must be executed by the Plan Sponsor no later than December 31, 2021.