Note: This article references content from The Flex Plan Handbook, with thanks to editor Rich Glass of Mercer, LLC.

Generally speaking, money contributed to a health flexible spending account (FSA) in any plan year can be used only to reimburse qualified expenses incurred during that year; money not used to reimburse eligible medical expenses incurred during the plan year is forfeited.

The unused portion of a participant’s health FSA may not be paid to the participant in cash or any other benefit. Arrangements outside a cafeteria plan adjusting salary to compensate for health FSA forfeitures may jeopardize the qualification of the FSA under Section 125 because this could be viewed as impermissible risk-shifting.

Forfeitures are calculated after the expiration of an optional “run-out” period (typically 3 months). While employers are not required to offer run-out periods, they allow employees to continue submitting claims for reimbursement during a specified time following the end of the year. During that period, reimbursement is drawn against the prior year’s health FSA for claims incurred during the previous plan year only.

Because the “use-or-lose” rule requires employees to forfeit any money that is left in their health FSA at the end of the plan year, it is the health FSA rule that is most relevant to employees. However, there are two key exceptions employers should be aware of.

Grace Period

An employer may offer employees a grace period of up to 2 months and 15 days to incur and be reimbursed for qualified medical expenses from their FSAs, if the cafeteria plan document provides for this. The grace period, unlike the run-out period discussed above, essentially extends the length of the reimbursable year itself rather than merely the period for submitting claims from the previous 12 months.

In 2013, the Internal Revenue Service gave employers another option: In Notice 2013-71, the agency announced that health FSAs can have up to a $500 carryover of un­used amounts from the prior plan year to the next plan year.

A health FSA carryover limit may be less than $500, and carryovers are optional. Employers do not need to adopt them. On the first day of the new plan year, the entire carryover amount is available. Note that a participant in the prior plan year need not participate in the health FSA in the new plan year to qualify for the carryover.

Employers Must Choose One or the Other (or Neither)

An employer cannot have a health FSA with both a carryover and a grace period. The two health FSA features are incompatible. Therefore, an employer that offers a health FSA with a current grace period must eliminate that period by the same deadline that applies to the carryover.

Which is Better?

Readers have asked us whether it’s better to offer a carryover or a grace period, and the answer is a firm “it depends.”

While both grace periods and carryovers tend to reduce the frantic year-end employee rush to spend unused FSA dollars, the grace period merely delays the panic by a few months.

For employers, allowing carryovers (which can continue carrying over year after year) can add to administrative and recordkeeping burdens. From the employee perspective, depending on an individual employee’s medical spending, it’s a toss-up as to whether it’s preferable to have $500 to use anytime during the following year (carryover) vs. potentially a larger amount that must be used by mid-March (grace period).

Good Communication is Key

Regardless of whether you adopt a grace period, a carryover, or neither, it’s important to educate employees about the importance of accurately predicting their annual out-of-pocket medical expenses. This would include deductibles, copayments, and all anticipated reimbursable expenses. Generally, it is better to underestimate the expenses and pay a little extra tax than to overestimate expenses and forfeit money.

Additionally, to help reduce forfeitures, employees should be notified of their health FSA balances before the plan year ends. Three months’ notice should be sufficient, although many employers already provide monthly or quarterly health FSA reports as part of their employee communications. This advance notice period should allow employees time to schedule nonessential medical or other care so that the entire amount in a health FSA can be used.