IRS Relaxes "Use It or Lose It" Rule for Cafeteria Plans

by Clark Williams

July 2005

The "use it or lose it" rule has long been familiar to participants in "cafeteria plans," also known as "flex plans" or "125 plans." Under this rule, amounts contributed by participants from their salaries or wages on a pre-tax basis must be spent on qualifying expenses (e.g., medical reimbursement or dependent care) by the end of the plan year (usually December 31). Any amounts not spent by then are forfeited to the employer-sponsor. This often leads to a year-end "spending spree" by participants on eyeglasses, dental services and other discretionary expenses to drain unused amounts from their accounts to avoid forfeitures.

On May 18, 2005 the IRS relaxed this rule to allow participants an extra 2½ months after the end of the plan year (March 15 for calendar year plans) to spend these amounts. This will allow participants greater opportunity to avoid forfeitures and allow participants to use their accounts more effectively.

Cafeteria plans are still prohibited from allowing "carryovers" from one year to the next, or "conversions" (e.g., to spend unused medical funds on dependent care), or "cash outs." So this 2 ½ month extension of the "use it or lose it" rule is the first significant relaxation of the stringent cafeteria plan rules since those rules first became effective in 1984.

To take advantage of this extension, the cafeteria plan document itself must expressly provide for this 2½ month rule. If you are one of our many clients for whom we have drafted your cafeteria plan, and if you would like to offer this new opportunity for your participants, please contact us to prepare an appropriate amendment to your plan document.