FSAs, DCAPs, and COVID-19

January 25th, 2021 by Thomas Harte

At the end of 2020, Congress passed a second COVID-19 stimulus package – the COVID-Related Tax Relief Act of 2020 (COVIDTRA) and the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (TCDTR), both part of the Consolidated Appropriations Act, 2021 (CAA, 2021). The President signed the bill into law on December 27, 2020. This package included regulatory relief for certain rules impacting health flexible spending accounts (FSA) or health FSAs and dependent care assistance plans (DCAPs), many of which were “underspent” at the end of 2020 because of the impact of COVID-19 on how Americans were able to access health care services and childcare services. Many childcare centers closed for most of or all of 2020, summer camps that provided childcare did not open, and many individuals chose to forgo elective or non-emergency healthcare procedures that they anticipated spending health FSA funds on.

A health flexible spending account (HFSA) is a self-insured medical reimbursement plan, used as a flexible spending arrangement.  An FSA is a tax-favored vehicle that allows employees to spend pre-tax money on qualified medical expenses. FSAs can be funded by just an employee, or by both an employer and employee. DCAPs are similar, but instead of health care services, the money can be spent on certain childcare expenses. Because of their tax favored status, these accounts are subject to many regulations and federal oversight.

Use-or-Lose Generally

Health FSA funds are use-or-lose. Contributions not used to reimburse expenses during the coverage year cannot be carried over and are forfeited unless the following applies:

  • Grace period provisions. Employers can provide a grace period of up to two months and fifteen days during which a participant may spend unused amounts for qualified expenses during the two month and fifteen-day period. The grace period must be provided for in the plan documents. A grace period is not the same as giving employees additional time to submit old receipts
    for expenses incurred during the standard plan year.
  • Carryover provisions. Employers can design their FSA to allow for a carryover into the next plan year of up to 20% of the FSA contribution limit (rounded to the next lowest multiple of $50), so $550 for 2021 (20% of $2,750). Employers can structure their plan so that less than this amount can be carried over. Carryovers do not count against contribution limits, but the carryover must be provided for in the plan documents.
  • Qualified Reservist Distributions. Employees who are in the US military who are ordered or called to active duty may receive a portion or all their health FSA account balances included in their gross income. The qualified reservist distribution is an exception to the general rule, permitting a distribution without qualified medical expenses and if taken, is not provided tax-free.  Employers that simply allow employees more time to submit receipts for expenses incurred during the standard plan year are not using a grace period or a carryover, that practice is called a run out period.

Employers cannot utilize both the carryover and grace period provisions- they must select one or the other DCAPs are also use-or-lose. Traditionally there are no carryover provisions for DCAPs, but grace periods are permitted to allow participants up to 2 months and fifteen-days to incur and submit expenses for reimbursement.

  • Special COVID Relief – Carry Over:  Employers offering a DCAP or health FSA may allow participants to carry over all unused DCAP and health FSA contributions or benefits remaining at the end of the 2020 plan year to the 2021 plan year.  Furthermore, employers offering a DCAP or health FSA may allow participants to carry over all unused DCAP and health FSA  contributions or benefits remaining at the end of the 2021 plan year to the 2022 plan year.
  • Special COVID Relief – Grace Period:  Employers offering a DCAP or health FSA may extend the grace period for using any benefits or contributions remaining at the end of a plan year ending in 2020 or 2021 to 12 months after the end of the applicable plan year.
  • Special COVID Relief – Spend Down:  Similar to DCAPs, employers offering a health FSA may allow participants who cease participation during the 2020 or 2021 plan year to continue
    to be reimbursed from any unused benefits through the end of the plan year (and applicable grace period) in which participation ceased.  This is often referred to as a “spend down” provision when included in a traditional DCAP.

Making Changes

Employers who wish to take advantage of this special relief may retroactively amend their plans, so long as any amendment is adopted no later than “the last day of the first calendar year  beginning after the end of the plan year in which the amendment is effective.” Employers should ensure they are operating their plan consistent with the terms of the amendment until the amendment is formally adopted. For calendar year plans, changes to the 2020 plan year must be made by December 31, 2021, and changes to the 2021 plan year must be adopted on or before December 31, 2022. Changes will need to be appropriately communicated to employees.

Some employers might choose not to allow these extended carryover or grace period changes. They might not wish to amend their plan, they might be in the process of terminating a plan, or they might have a small number of underspent accounts. Other employers might choose to extend relief to one type of account (FSA or DCAP) and not the other, and some might choose to allow the extended grace period or carry over, but not allow individuals to make changes outside of the long-held qualifying event rules. Employers that decide not to avail themselves to the relief, or only certain parts of it, should strongly consider communicating their decision to employees in order to prevent employee relation issues.

“Stacking” COVID Relief

In May of 2020 the IRS released a notice that allowed employers with FSAs and DCAPs ending prior to December 31, 2020 (noncalendar year plans) to extend the grace period or spend down provision guidelines to December 31, 2020. Employers with these non-calendar year plans may now allow the more generous grace period provision of 12 months after the end of the applicable plan year, even if they previously used the first extended grace period to the end of 2020. Their plan should be updated for the second time to allow this.

Dependents Aging Out

Dependent care accounts can only be used for the care of qualified individuals, typically the dependent of a taxpayer who has not yet turned 13 (or certain qualified relatives who are unable to care for themselves). To account for underspent accounts held by employees whose children turned 13 during the pandemic, the relief allows the employer to substitute “age 14” for “age 13” for
purposes of determining eligibility for reimbursement of a child’s expenses.

Change in Status Event “Relief”

In a regular year, employees can only make changes to their FSA elections if they experience a change in status event. Under the relief rules, employees can make prospective mid-year changes in 2021 without experiencing a change in status. Otherwise, Regular Rules Apply Other than the specified changes in the legislation, employers cannot make any other traditionally prohibited changes to their plan. For example, employers cannot require employees who enroll in the FSA mid-year to fully fund the FSA within a few pay periods. Employers cannot allow FSA or DCAP funds to be used for expenses that are not permitted by the IRS. Employers are not permitted to reimburse employees underspent funds, minus applicable taxes. Employers are limited with what they can do with money remaining in underspent accounts after all grace periods and carryovers have been exhausted.

Employers That Utilize the Relief but Also Have HDHP/HSA Plans – Be Cautious

FSAs create unique challenges for individuals who wish to establish an HSA. At a basic level, an individual cannot have FSA coverage and HSA coverage at the same time. Issues arise on determining when a person is no longer considered to have FSA coverage.  Employers should note that some employees with remaining balances could be “locked out” of HSA participation for some time, if they had switched from an FSA plan to an HDHP with HSA in 2021 or 2022 and the employer chose to use the extended relief due to COVID-19.

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