FSA Experience Gains from Forfeitures

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FSA Experience Gains from Forfeitures

By Brian Gilmore | Published October 28, 2021

Question: What options do employers have with how to use experience gains from health FSA or dependent care FSA forfeitures?

Short Answer: The Section 125 regulations provide employers with three options to allocate experience gains from health FSA forfeitures. The dependent care FSA provides employers with an additional option to retain the forfeitures. Regardless, employers overwhelmingly choose to use experience gains from forfeitures to cover all or a portion of the FSA’s administrative expenses.

General Rule: The FSA Use-It-Or-Lose-It Rule

The health FSA and dependent care FSA are components of an employer’s Section 125 cafeteria plan. Section 125 (and its implementing regulations) imposes very strict requirements on the administration of cafeteria plans.

One of the most fundamental of these limitations is that all FSA elections are subject to the use-it-or-lose-it rule. The rule requires forfeitures of any remaining unreimbursed funds not subject to a carryover provision after the end of the plan year (or earlier termination of employment) and any grace period and/or run-out period.

There is no option for employers to make exceptions to these rules or directly or indirectly refund to employees any unreimbursed FSA amounts remaining following termination of employment or at the end of the plan year, plus any related grace period and/or run-out period (subject to any carryover). Engaging in this practice would risk disqualifying the entire Section 125 cafeteria plan if discovered by the IRS, potentially resulting in all elections becoming taxable to all employees.

Experience Gains from Health FSA Forfeitures: Permitted Uses

The Section 125 regulations generally provide the following three permitted plan uses of experience gains resulting from health FSA forfeitures:

There is no option for employers to make exceptions to these rules. Failure to allocate experience gains consistent with these options would risk disqualifying the entire Section 125 cafeteria plan if discovered by the IRS, potentially resulting in all elections becoming taxable to all employees.

Note that experience gains are the result of annual forfeitures reduced by the health FSA’s losses from overspent accounts by employees who terminate mid-year. The experience gains (if any) may be significantly lower than the gross forfeiture amount if there are many mid-year terminations with overspent accounts.

Employers should consult the terms of the Section 125 cafeteria plan to confirm whether all three approaches are available under the plan. Employers should also keep records of experience gain amounts available and their application under one of these permitted three approaches.

Option 1: Uniformly Reducing Required Salary Reduction Amounts in Subsequent Plan Year (Uncommon)

Employers choose to apply experience gains from forfeitures to the plan’s administrative expenses in the vast majority of situations. It is uncommon for employers to use forfeitures for any purposes other than to cover all or a portion of the health FSA’s administrative expenses.

For the rare situations where the employer chooses to utilize the option to apply health FSA experience gains (forfeitures reduced by losses from overspent mid-year terminations) to reducing employees’ required contributions for the following plan year, the experience gains are spread evenly among all participants—regardless of whether they forfeited any amount. Therefore, the approach generally results in a small contribution reduction for each employee. That allocation will in no way reflect each employee’s particular claims experience (i.e., forfeitures) from the prior plan year.

Option 2: Uniformly Returning Funds to Employees (Uncommon)

For the rare situations where the employer chooses to utilize the option to return the health FSA experience gains to participants, the rules permit employers to provide cash refunds “on a reasonable and uniform basis.” This approach does permit refunds based on the amount of any forfeitures experienced by a particular participant.

Option 3: Applying to Health FSA Administrative Expenses (Very Common)

Employers almost always apply experience gains from health FSA forfeitures to the cost of administering the health FSA. Most often the funds are applied to the TPA’s service fee to administer the plan. This is the simplest and least burdensome approach.

Experience Gains from Dependent Care FSA Forfeitures: Permitted Uses

The same three permitted uses of experience gains from health FSA forfeitures described above also apply to dependent care FSA forfeitures.

However, employers also have one additional option with dependent care FSA forfeitures: The employer may simply retain the dependent care FSA experience gains in the employer’s general assets for any use or purpose—even those unrelated to the plan.

Commuter Benefit Forfeitures: Different Rules Apply Under §132

Commuter mass transit/vanpool and parking benefits are not cafeteria plan benefits. Rather, they are governed by Section 132(f).

The §132 rules are clear that only current employees can participate in the commuter account. Furthermore, the prohibition on refunds or cash outs of unused commuter account balances extends to situations where the employee ceases to participate, such as participation of employment.

The good news is employers may retain commuter account forfeitures, allocate them evenly to the accounts of other commuter participants, use the amounts for plan administrative expenses, or use them any other purpose. Unlike the Section 125 cafeteria plan rules applicable to experience gains caused by FSA forfeitures, there are no Section 132 rules governing employer use of forfeitures.

Regulations

Prop. Treas. Reg. §1.125-5(o):

(1) Experience gains in general. An FSA experience gain (sometimes referred to as forfeitures in the use-or-lose rule in paragraph (c) in this section) with respect to a plan year (plus any grace period following the end of a plan year described in paragraph (e) in §1.125-1), equals the amount of the employer contributions, including salary reduction contributions, and after-tax employee contributions to the FSA minus the FSA’s total claims reimbursements for the year. Experience gains (or forfeitures) may be—

(i) Retained by the employer maintaining the cafeteria plan; or
(ii) If not retained by the employer, may be used only in one or more of the following ways—

(A) To reduce required salary reduction amounts for the immediately following plan year, on a reasonable and uniform basis, as described in paragraph (o)(2) of this section;
(B) Returned to the employees on a reasonable and uniform basis, as described in paragraph (o)(2) of this section; or
(C) To defray expenses to administer the cafeteria plan.

(2) Allocating experience gains among employees on reasonable and uniform basis. If not retained by the employer or used to defray expenses of administering the plan, the experience gains must be allocated among employees on a reasonable and uniform basis.

(3) Example: The following example illustrates the rules in this paragraph (o):

(i) Employer L maintains a cafeteria plan for its 1,200 employees, who may elect one of several different annual coverage levels under a health FSA in $100 increments from $500 to $2,000.

(ii) For the 2009 plan year, 1,000 employees elect levels of coverage under the health FSA. For the 2009 plan year, the health FSA has an experience gain of $5,000.

(iii) The $5,000 may be allocated to all participants for the plan year on a per capita basis weighted to reflect the participants’ elected levels of coverage.

Author: Brian Gilmore
Lead Benefits Counsel, VP, Newfront
Brian Gilmore is the Lead Benefits Counsel at Newfront. He assists clients on a wide variety of employee benefits compliance issues. The primary areas of his practice include ERISA, ACA, COBRA, HIPAA, Section 125 Cafeteria Plans, and 401(k) plans.