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IRS Permits New Grace Period for Section 125 Cafeteria Plans

June 07, 2005

The IRS recently issued Notice 2005-42, which modifies the "use-it-or-lose-it" rule for Internal Revenue Section 125 cafeteria plans. This notice permits plans to provide a grace period of up to 2½ months following the end of each plan year during which plan participants may incur qualified expenses which then may be paid or reimbursed from the prior plan year's election amounts.

Eligible Benefits
This new grace period may be applied to all eligible benefits under a Section 125 cafeteria plan, including health flexible spending arrangements (FSAs), dependent care assistance programs, and adoption assistance programs.

Length of Grace Period
The new grace period may extend up to 2½ months beyond the end of the preceding plan year. This would give a participant up to 14 months and 15 days (instead of only 12 months) to use the benefits or contributions for a plan year before those amounts would be forfeited under the use-it-or-lose-it rule. The grace period must apply to all participants in the plan.
During the grace period, the plan may not permit unused benefits or contributions to be cashed out or converted to any other taxable or nontaxable benefit. For example, unused amounts elected to pay or reimburse medical expenses in a health FSA may not be used to pay or reimburse dependent care or other expenses incurred during the grace period.

As is the case now, employers may continue to provide a "run-out" period after the end of the grace period, during which expenses for eligible benefits incurred during the plan year and the grace period may be paid or reimbursed.

Effective Date and Implementation
This new rule is effective immediately. However, the new grace period is not mandatory, and will apply only if the plan document is amended, by the end of the plan year, to add the grace period. For calendar year plans, this means that the plan amendment would have to be adopted by December 31, 2005 to permit a grace period, beginning on January 1, 2006 and ending no later than March 15, 2006, for 2005 election amounts.

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