Cafeteria Plans: "Use It or Lose It" Rule Expanded

IRS rules governing cafeteria plan operations generally prohibit unused benefits and contributions remaining in a cafeteria plan at year end from being used to pay or reimburse benefit expenses incurred after that time. This "use it or lose it" rule has caused many plan participants to forfeit potential plan benefits. Recently, the IRS has relaxed the harshness of this rule. Under Notice 2005-42, a cafeteria plan may permit unused benefits and contributions remaining at the end of a plan year to be applied to expenses incurred during the first two and one-half months of the following plan year. If a plan sponsor decides to amend the plan to implement this new rule, the plan must be amended on or before the last day of the plan year to which this rule would first be applied. For example, if a plan participant in a calendar year plan has $100 left in his medical flexible spending account on December 31, 2005, he may use the $100 to pay medical expenses he incurs between January 1 and March 15, 2006, provided his cafeteria plan has been amended to reflect this new rule on or before December 31, 2005.

We anticipate that the IRS will likely post additional information on IRS Notice 2005-42 on the IRS's website at www.irs.gov/ebsa.