What Can An Employer Do With Forfeited FSA Funds?

Many employers use flexible spending accounts (FSAs) to help employees pay for their medical-related expenses. Years ago, the “use it or lose it” rule was the main guideline for how employees could spend their money. Under this rule, employees forfeit any leftover money to you at the end of their plan year. Now, you have more options to offer employees when dealing with unused FSA funds.

Read on to learn about FSAs and what happens to unused FSA funds.

What is an FSA?

A health flexible spending account (FSA) is a medical spending account you can offer your employees. Think of it like a bank account for medical expenses. Employees contribute pre-tax money to their FSA each month through payroll deductions. Employees then use their FSA funds to pay for qualifying medical expenses. 

Employees can use their FSA funds to pay for medical expenses, like:

• Copayments
• Deductibles
• Qualifying prescriptions

FSA funds also cover other qualifying healthcare costs. Because employee contributions are pre-tax, FSAs can help reduce an employee’s taxable income. 

There are two conditions to FSA funds that employees should know:  

1. There is a limit to how much money an employee can contribute for the year
2.  Unused funds are typically forfeit once the plan year ends

How much can employees contribute?

There is a limit on employee contributions to FSA funds. For 2022, the maximum salary deferral contribution is $2,850. Employees can choose their contribution level for the year. To contribute to their FSA, an employee pays a portion of their annual contribution across their pay periods for the entire year. 

For example, if an employee wants to contribute the maximum amount of $2,850 across 26 pay periods, they would contribute $109.62 each paycheck ($2,850 / 26). Employees can access the full amount of their FSA fund as soon as the plan year starts, regardless of the amount of money they’ve contributed. If the same employee has a medical expense in June that is $2,000, their FSA will cover it even though they haven’t contributed $2,000 into the plan.

Because employees must use FSA funds in a specific timeframe, FSAs benefit those with dependable and recurring medical expenses.

How long can employees use their FSA funds?

FSA funds come with an expiration date, known as the “use it or lose it” rule. Under this rule,  employees must use their FSA funds within the plan year. But, what happens to FSA funds not used? In the past, all unused funds at the end of the plan year were forfeited to employers. Now, you have two options to offer employees to help them use some of their unused funds (more on these options below). But, forfeited funds may still happen.

You may be wondering, Why wouldn’t an employee spend all of their FSA funds in the plan year? There are several reasons an employee may not spend all of their funds for the year. 

It’s possible that employees:

• Elected to contribute too much money to their FSA fund at the beginning of the year
• Had a change in their medical needs over the year
• Misunderstood the expenses required for their medical needs

If your employees do forfeit funds to you, there are a few ways those forfeited funds can still benefit your employees. 

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What happens to unused FSA funds?

Under the “use it or lose it” rule, employees must forfeit all unused FSA funds. But, where do unused FSA funds go? Unused FSA funds are forfeited to you, the employer. You may be wondering, Can an employer refund unused FSA funds? The short answer is yes, but there are a few other options to consider before you decide on a refund. 

When dealing with forfeited funds, remember to:

1. Handle forfeited funds properly
2. Be equitable
3. Think of offering other options

1. Handle forfeited funds properly

If you find yourself with forfeited FSA funds, you may be wondering what you can do with them. You can either:

1. Defray the cost of administrating the FSA program
2. Reduce employee contributions
3. Increase the annual coverage amount
4. Distribute forfeited funds as a cash refund 

Defray the cost of administrating the FSA program

If you use a third-party administrator (TPA), you can pay them with forfeited funds as long as you meet all three of the following:

• The FSA plan doesn’t prohibit paying the TPA
• Funds don’t help pay for a different FSA plan
• The expenses are directly related to the FSA

Reduce employee contributions

You can use forfeited funds to reduce employee contributions for the upcoming FSA plan year in a reasonable and uniform way. If you reduce employee contributions, employee take-home pay will temporarily increase as will their tax liability. Once you exhaust forfeited funds, employee paychecks and tax liability will return to normal. 

Let’s say an employer has $2,000 in forfeited funds and has 10 employees. The employer uses the forfeited funds to reduce employee contributions for the plan year. Each employee will have $200 ($2,000 / 10) already contributed to their FSA. Once the employer has exhausted the $2,000 in forfeited funds, employee contributions will return to their previous level. 

You must use the forfeited funds in the year you discover them. For example, if you discover the forfeited funds from 2022 in 2023, you must use them for the 2023 plan year. 

Increase the annual coverage amount 

You can increase the annual coverage amount for the next year as long as it doesn’t exceed the maximum election limit and is equal for all employees. For example, suppose your forfeited funds total $1,000. In that case, you can add this money equally to your employees’ elected contribution limits as long none of their increased contributions exceed the maximum election limit. 

Employee contributions stay the same each month, but the amount of their FSA will be higher for the year than their elected annual contribution limit.

Distribute forfeited funds as a cash refund

Again, you can distribute forfeited funds as a cash refund to employees as long as they contributed to the FSA. If employees with FSAs left the company, you may have to track them down to give them their refund. Also, remember that once you offer a cash refund to employees, that money is subject to payroll taxes.

2. Be equitable

When using forfeited FSA funds in ways that directly influence your employees (e.g., reducing employee contributions, increasing the annual coverage, or distributing funds as cash), you must keep some things in mind.

When distributing forfeited funds, make sure you:

• Distribute equal amounts to each employee or use a weighted average based on the employee’s level of contribution
• Distribute forfeited funds to employees regardless of their FSAs balance

You cannot favor one employee or a group of employees over others for any reason when distributing forfeited funds.

3. Think of offering other options

The “use it or lose it” rule isn’t set in stone. You can offer employees two options that may help them keep some of their forfeited funds. If you’d like to offer your employees a way to extend their FSA funds past the “use it or lose it” deadline, you can offer the:

1. FSA grace period
2. FSA carryover rule

You cannot choose both of these options, only one. Whatever you decide, keep your employees in mind and offer an alternative that meets their needs.

1. FSA grace period

One of the options you can offer your employees is the FSA grace period. The grace period adds 2.5 months to the original plan year. Employees have 14 months and 15 days to spend their unused FSA funds under the grace period. The grace period gives employees extra time to spend their funds and incur new expenses before unused funds are forfeited. 

Any claims submitted during the 2.5-month grace period automatically use the previous year’s funds before the funds from the current year. 

Let’s say an employee contributes $1,000 to their FSA fund for the year. But, by the end of December, it’s obvious that they won’t be able to use $200 of their FSA in the current year. With the FSA grace period, the employee will have until early March to use their funds before they are forfeited. 

2. FSA carryover rule

Another option you can offer employees is the FSA carryover rule. The FSA carryover rule lets account holders carry over up to $570 of their unused funds into the following year. Any unused funds over $570 will be forfeited to you.

Let’s look at an example of this in action. An employee decides to contribute $2,000 to their upcoming plan year, and they have $200 carryover from the previous year. The employee has two options for their carryover funds. They can: 

1. Increase their annual coverage by $200. If the employee chooses to add the carryover funds to next year’s total, it will increase their funds for the upcoming year by $200. The new total for their upcoming year would be $2,200 (2,000 + 200).
2. Reduce their contribution by $200. If the employee chooses to reduce their contribution total, they can use the $200 to make up the difference. Their overall contribution remains the same, but the employee pays less for the year. 

Deducting FSA contributions doesn’t have to be difficult. Patriot’s online payroll helps you easily manage employee FSA deductions. Sound too good to be true? Try it for free today!

This article has been updated from its original publication date of January 11, 2016.

This is not intended as legal advice; for more information, please click here.