Health flexible spending arrangements (FSAs) are subject to the use-or-lose rule, meaning that any unused funds remaining in the health FSA at the end of its plan year are generally forfeited by the participant, subject to limited plan design exceptions. The forfeited funds are referred to as “experience gains,” and become available to the plan sponsor for restricted use. This article will describe the exceptions to the use-or-lose rule and how plan sponsors may use experience gains.
Exceptions to the Use-or-Lose Rule
Carryovers and grace periods are optional plan design features a plan may implement that function as an exception to the use-or-lose rule. A health FSA plan may implement either a carryover or grace period but not both. Both have a potential effect on a participant’s HSA eligibility for the subsequent plan year that should be taken into consideration.
Carryovers
Health FSAs may offer carryovers of up to a specified limit (indexed annually – $680 for 2026) of any remaining funds at the end of a plan year to be available to reimburse qualified medical expenses incurred in a subsequent plan year. Any unused amounts remaining in the health FSA at the end of the plan year that exceed the maximum carryover amount will still be forfeited. The carryover amount will not count against the limit on annual health FSA salary reductions in a subsequent plan year (i.e., an employee with a carryover balance from the 2025 plan year could still elect up to $3,400 for the 2026 plan year).
A plan may set the maximum carryover limit lower than the indexed amount. The plan could also be designed to limit the ability to carryover unused funds. For example, some plans require employees make an election to contribute to the health FSA in the next plan year in order to carryover a previous year’s balance, while other plans require a minimum unused balance to carryover (e.g., must have $100 or more remaining to carryover with no new contribution election for the next plan year). Without such limit, the carryover balance could continue to be available indefinitely, as long as the employee remains eligible for the health FSA and could extend COBRA continuation obligations.
Carryovers can also affect COBRA continuation obligations. For health FSAs, when a qualifying event causes a loss of eligibility, COBRA continuation must be offered if the health FSA is underspent (i.e., if the balance remaining in the health FSA exceeds the COBRA premiums that would be required for the remainder of the plan year). In determining whether the account is underspent, guidance in IRS Notice 2015-87 (Q&As #21-23) indicates that the benefit still available includes the carryover amount, but the COBRA premium should not take the carryover into account. If the benefit still available for the plan year, including the carryover, exceeds the amount the employee would have to pay via COBRA premiums for the remainder of the plan year, COBRA should be offered.
Grace Periods
In general, health FSA funds can only be used to pay for or reimburse qualified medical expenses that are incurred during the health FSA’s plan year. However, as a plan design feature, health FSAs may implement a grace period of up to 2.5 months after the end of a plan year. With a grace period, participants may access any remaining unused amounts at the end of the immediately preceding plan year to pay for qualifying medical expenses incurred during the grace period. Any unused amounts remaining in the health FSA at the end of the grace period will then be forfeited.
NOTE: The grace period is different than the plan run-out period. Whether the plan year offers a carryover or grace period feature, or neither one, the plan will typically provide a period of 60-90 days beyond the plan year to submit receipts for reimbursable expenses that were incurred during the health FSA plan year. The run-out period does not provide any additional time to incur expenses.
Impact on HSA Eligibility
Participation in a general-purpose health FSA causes a loss of HSA eligibility for the duration of the health FSA plan year, even after the health FSA balance is $0. If the health FSA has a zero balance at the end of the plan year and the participant doesn’t elect to participate in the health FSA the following plan year, then the participant will be HSA-eligible (assuming enrollment in a qualifying HDHP and no other disqualifying coverage). However, if there is a remaining balance in the health FSA at the end of the plan year and the health FSA features either a carryover or grace period, HSA eligibility will be affected.
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If the health FSA has a carryover, a participant with a remaining health FSA balance at the end of the plan year will be HSA-ineligible for the entire plan year immediately following the health FSA’s plan year. This is true unless the balance is waived or the balance is transferred to an HSA-compatible health FSA (i.e., a limited-purpose FSA; a post-deductible FSA, or a combination of the two).
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If the health FSA has a grace period, the participant will be HSA-ineligible until the grace period is over. The employer could make the grace period a limited-purpose and/or post-deductible during the grace period only, but must do so on a uniform basis
for all (i.e., participants could not be given a choice between a limited-purpose or general-purpose health FSA). Employees who have a significant balance or who are not participating in the HDHP may not like this option. Without making any changes, the problem may be somewhat alleviated by the “full-contribution” rule for HSAs, which allows an individual who is HSA-eligible for only a portion of the year to make a full year’s worth of HSA contributions, so long as certain additional requirements are met. As a result, short periods of HSA ineligibility due to a grace period may affect timing but will not necessarily prevent full HSA contributions.
Experience Gains
Some participants will underspend their health FSAs due to not incurring enough eligible expenses during the plan year, while others may overspend their accounts if they submit expenses for reimbursement up to the full annual election early in the plan year and then participation in the plan ends mid-plan year. The forfeitures the employer obtains from the underspent accounts may be used to offset any losses from the overspent accounts. If there is money left over after covering the reimbursements provided during the plan year, those experience gains should be used by the employer in accordance with IRS and ERISA requirements.
In general, there are four options for utilizing experience gains that comply with both IRS and ERISA requirements: (I) defray plan administration expenses; (II) reduce salary reduction amounts for the following plan year; (III) increase the annual coverage amount; or (IV) provide to employees as a cash refund. Under ERISA, experience gains that are plan assets generally cannot be retained by the employer.
Options for Experience Gains
Defray Plan Administration Expenses
Reasonable administration expenses are those that relate specifically to the health FSA’s administration and are not an ERISA prohibited transaction. Such expenses may include the fees paid to a service provider.
Reduce Required Salary Contributions
The employer could use the experience gains to reduce the required salary contribution (or provide a “premium holiday”). This option is often attractive to employers as it is administratively convenient and best complies with both IRS and ERISA requirements.
Increase Annual Coverage Amount
The employer could increase the amount available for reimbursement for the plan year in addition to what was elected by the employee (similar to an employer contribution to the health FSA). This could be above and beyond the annual contribution limit that applies to employee salary reductions. However, this option may not be as attractive as coverage may not stay at the higher level and may contribute to experience gains again for the following year.
Provide Cash Refunds
Another option is to allocate experience gains to participants in cash. If cash is returned, the amounts will be taxable wages.
***If the employer distributes the experience gains as a premium holiday, increases the annual coverage amount, or provides a taxable cash refund, the allocation of experience gains must be on a reasonable and uniform basis, and NOT on the basis of individual claims experience.
Unison Risk Advisors Compliance Team | benefitscompliance@unisonriskadvisors.com
Disclaimer: Materials are solely for informational purposes as an educational resource. Please contact counsel to obtain advice with respect to any specific issue.
