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Health Care Reform Spurs Further Changes to Health FSA and COBRA Rules
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This article was written for publication in the January, 2014 issue of the New Hampshire Employment Law Letter, a newsletter written for New Hampshire employers by the labor and employment attorneys at Sulloway & Hollis and published by BLR® – Business & Legal Resources.
The Patient Protection and Affordable Care Act (a/k/a the “ACA” or “Health Care Reform”) has brought profound changes to the world of employee health benefits. These changes will accelerate in the coming years as the coverage mandate generally applicable to employers with 50 or more full-time employees takes effect, now scheduled for 2015. Apart from all the “big-picture” issues trumpeted in media reports, less publicized but still important developments in this field demand the attention of HR and benefits professionals.
Background: Health FSA Plans
The popular health FSA plan is a type of “cafeteria plan” authorized by Section 125 of the Internal Revenue Code. Section 125 permits employers to offer plans letting employees choose between cash and one or more “qualified benefits,” including the reimbursement of certain medical expenses. Under a health FSA plan, employees annually designate a portion of their compensation to be placed in an account, which the employee may draw upon as needed to reimburse him or her for expenses, including deductibles, copayments and other health care costs not covered under the employer’s core health insurance program, such as vision and dental care and certain medications. Contributions and expense reimbursements are both nontaxable to the employee for income and employment tax purposes.
Historically, health FSAs have been subject to a “use it or lose it” requirement, under which unused amounts remaining in the account at the close of the plan year are forfeited by the employee. However, since 2005, the IRS has permitted plans to provide a 2 ½ month grace period following the close of the plan year, with unused prior-year account balances being available to cover eligible expenses incurred during that period.
The ACA and Its Aftermath
Since enactment of the ACA in 2010, the general trend has been to restrict the availability and use of health FSAs, both for policy and budgetary reasons, as discussed in the article entitled “Health Care Reform Leads Congress to Backtrack on Health Flexible Spending Accounts,” which appeared in our August 2010 issue. For example, health FSAs may be used in conjunction with health spending accounts (HSA’s) and their companion high deductible health insurance plans (“HDHP”) only for very limited purposes. More recently, under the ACA, annual health FSA contributions were limited to $2,500 beginning in 2013, considerably less than the limits previously imposed by employers on their own. Also, pursuant to the Act, reimbursement is no longer available from health FSAs for most nonprescription medications.
Countering this general trend of restricting the availability and use of health FSAs, after a period of study, the IRS recently issued Notice 2013-71, announcing a further modification to the use it or lose it rule that permits health FSA plans to allow an unused balance of up to $500 remaining in the employee’s account at the end of the year to be used to provide reimbursement for qualifying medical expenses incurred at any time during the following plan year.
Compare and Contrast
As previously noted, since 2005, the IRS has permitted health FSAs to allow participating employees who have been unable to use their full FSA balance during the plan year to use any remaining balance to defray otherwise qualifying medical expenses incurred during the first 2 ½ months of the following year, essentially without limit. Thus, for example, assume that for 2013 the employee contributed $2,500 to his FSA account and at the end of the year has a remaining account balance of $2,000. Under this rule, if the employee incurred $2,000 of qualifying expenses between January 1 and March 15, 2014, the plan could reimburse him for these expenses from his 2013 account balance. The employee’s 2014 contribution limit would be unaffected, and he could obtain reimbursement to the extent of that limit for any expenses incurred between January 1, 2014 and the expiration of the subsequent year grace period in mid-March of 2015. Moreover, the plan can provide a “run-out period;” that is, an additional period afforded the employee to file claims after the close of the applicable grace period. However, expenses incurred during the run-out period are not eligible for reimbursement from the prior year account balance; only those incurred during the 2 ½ month grace period would qualify.
By contrast, the new carryover rule is more flexible in some respects and more restrictive in others. Unlike the current grace period rule, the new rule extends the period during which qualifying expenses may be incurred and reimbursed after the close of the regular plan year from 2 ½ to a full 12 months. Thus, to take the prior example, if the employee has an unused account balance of $2,000 at the end of 2013, but does not incur reimbursable medical expenses until sometime after mid-March, 2014, the new rule is preferable provided the expenses in question do not exceed the $500 carryover limit. Under the new rule, these expenses could be incurred as late as December 31, 2014 and still be reimbursed from the employee’s unused 2013 account- but only to the extent of the $500 limit.
On the other hand, while the length of the grace period under the 2005 rule is limited to 2 1/2 months after the close of the plan year in question, the potentially reimbursable amount of expenses that may be incurred during that 2 ½ month period is limited only by the unused amount remaining in the employee’s FSA account at the end of the prior year. Under the new rule however, as noted above, the maximum unused account balance that can be carried over is $500.
In a perfect world (assuming that a use it or lose it rule is required at all), employers would have the option of letting their employees take advantage of either (or potentially, both) of these rules from year to year and on an individual basis, depending upon their personal circumstances. Thus, if an employee had a significant FSA balance available for carryover at the end of the year but foresaw substantial expenses being incurred early in the subsequent plan year, plus some additional expenses later on (in excess of his actual contributions for that year, given the $2,500 limit), ideally the employee could both avail himself of the unlimited carryover reimbursement for the first 2 ½ months of the year and, if any unused balance remained, the rest of the account could be utilized later in the subsequent year, up to the $500 limit. Alternatively, the employee could avail himself of the grace period in one year and the $500 carryover in another, as circumstances dictated.
Unfortunately, however, the IRS in its recent notice specified that an employer may amend its plan to provide for the $500 carryover or continue (or introduce) the grace period, but not both. Therefore, if an employer wants to amend its health FSA plan to provide the flexibility afforded by the new $500 limit, if the plan currently provides for the 2 ½ month grace period, the employer must also amend the plan to remove the grace period. As the prior examples suggest, this change could work to the benefit or disadvantage of various employees, or of any given employee from year to year, depending upon the circumstances. While presumably it would be possible for the employer to amend the entire plan to switch from grace period to carryover (and back again), this could only be done on a year-by-year basis and, of course, such amendments must apply equally to all participating employees.
It should be stressed that both the grace period and the new $500 carryover are purely optional. No employer is required to draft or amend its plan to provide for either. Plans can thus provide for one type of relief or the other (or neither) – but not both.
In its notice, the IRS indicated that normally employers wishing to create or amend a plan providing for the new $500 carryover must do so prior to the close of the plan year from which amounts are being carried over, effective retroactively from the first day of that plan year. However, the Service has stated that plans may be amended to adopt the carryover provision for a plan year that begins in 2013 only at any time on or before the last day of the plan year that begins in 2014 (that is, December 31, 2014 for calendar year plans). In any case, the plan must be operated in accordance with the IRS Notice and other guidance, and participants must be informed of the carryover provision in a timely manner. This special rule will give employers additional time to assess the impact and relative attractiveness of both the old and new relief provisions, and make at least somewhat informed decisions as to the path they choose to follow.
However, in its Notice the IRS does note that, as expected, if a plan has provided for the 2005 grace period and is being amended to add the new carryover provision, the plan must also be amended to eliminate the grace period provision by no later than the end of the plan year from which amounts may be carried over. No exception appears to apply to this part of the rule with respect to the 2013 plan year. Therefore, if the amendment involves the elimination of the existing grace period, the amendment doing so would in fact need to be adopted by the end of the plan year from which amounts may be carried over. Therefore, if it is impracticable to adopt such an amendment by the close of 2013, it may not be possible to implement a switch from the old grace period to the new carryover period without delay.
Finally, in its Notice the Service also states that “the ability to eliminate a grace period provision previously adopted for the plan year in which the amendment is adopted may be subject to non-Code legal constraints,” such as ERISA requirements or the employer’s contractual obligations, for example, under a collective bargaining agreement. Employers must therefore exercise due care in making any plan amendments that would impermissibly impair or deny any rights participating employees may currently enjoy under the plan. For these reasons, employers’ ability to implement the new carryover provision promptly (i.e., with respect to carryovers of up to $500 of unused 2013 account balances into 2014), may be limited if their plans include the current grace period.
ACA Mandates Updated COBRA Notice
For many years, COBRA has required most larger employers to make continuation coverage under their group health plans available for limited periods to employees and other “qualified beneficiaries” who would otherwise lose their coverage under the employer’s group health plan; for example, due to termination of employment. While the employee must generally pay the full cost of this coverage (unless the employer chooses to subsidize the COBRA premium in some or all cases), this law has helped provide at least a modicum of access to group health plan coverage for employees and family members who would otherwise lose this coverage under these circumstances.
The rules governing the administration of COBRA continuation coverage are quite complex. One component of these requirements involves giving notices to the employee and qualified beneficiaries upon the initiation of group plan coverage and upon the occurrence of a “qualifying event”; i.e., an event that would otherwise cause the qualified beneficiary to lose coverage under the employer’s group health plan, thereby triggering eligibility for the qualified beneficiary to elect continuation coverage under COBRA.
With the advent of health care reform, and in particular the introduction of the health insurance “exchanges” or “marketplaces”, intended to make individual health insurance coverage more readily available and affordable, it has been theorized that COBRA continuation coverage will over time become less significant in the overall scheme of things. In any case, it is important that employees and other qualified beneficiaries who become eligible for COBRA coverage be aware that under reform they may have other, more attractive health insurance options available to them.
Accordingly, in Technical Release 2013-02, the U.S. Department of Labor’s Employee Benefits Security Administration issued an updated notice that under the Fair Labor Standards Act as amended by the ACA, employers are required to distribute, informing employees of their coverage options under the ACA. This notice was required not later than March 1, 2013. In conjunction with this requirement, the Department of Labor issued a revised model notice that plans can use to provide the required continuation coverage election notice under COBRA. The new election notice is essentially the same as the prior version, but includes the following new language:
“There may be other coverage options for you and your family. When key parts of the health care law take effect you’ll be able to buy coverage through the Health Insurance Marketplace. In the Marketplace, you could be eligible for a new kind of tax credit that lowers your monthly premiums right away, and you can see what your premium, deductibles and out-of-pocket costs will be before you make a decision to enroll. Being eligible for COBRA does not limit your eligibility for coverage for a tax credit through the Marketplace. Additionally, you may qualify for a special enrollment opportunity with another group health plan for which you are eligible (such as a spouse’s plan) even if the plan generally does not accept late enrollees, if you request enrollment within 30 days.”
Since many employers outsource their COBRA administration to their health insurance provider, third party administrator or other firm, the details of this notice may not be of great concern to those employers purely from the administrative standpoint. However, all employers should be aware that new sources of individual health insurance coverage could result in substantial savings for both employees and group health plans. Employers would thus be well-advised to equip themselves to direct their employees to sources of timely and accurate information concerning alternatives to COBRA continuation coverage.rs must be mindful that when drafting the NQDC plan, special care must be taken to coordinate the plan documentation with other employment agreements that may either exist or will come into existence. The terms of an employment agreement, for instance will generally address events of termination and the term “disability”, as a cause for termination is likely to differ from the term as defined by the IRS for 409A purposes. To avoid an impermissible accelerated distribution, it is important that all employment documents, including a general employee manual should be reviewed with an eye to the language in the NQDC plan.
At one time, it was thought that health FSAs would be a casualty of health care reform. To date they have survived, but with a reduced scope. However, the limited carryover afforded by the recent IRS Notice introduces a welcome element of flexibility to the use it or lose it rule, as an alternative to the relief previously granted under the 2005 grace period. Employers will need to determine whether it is worthwhile to amend their plans to introduce the new carryover, even if doing so requires the deletion of that grace period. On other fronts, with the advent of reform, the role of COBRA continuation coverage will continue to evolve and change, in view of the increased availability of other coverage options for employees and their families through the individual health insurance marketplaces.