Employees who set aside pretax dollars in a health flexible spending account face a familiar year-end problem: any money left unspent after December 31 disappears. The IRS default rule treats unused FSA balances as forfeited once the plan year closes, and most employer plans still follow that structure. Two relief options exist, a grace period of up to two months and 15 days or an annual carryover tied to 20 percent of the salary-reduction cap, but a plan cannot offer both, and neither is automatic.
How the FSA Forfeiture Rule Took Shape
The use-or-lose requirement has been federal tax policy for decades, but the IRS began softening its edges in stages. In 2005, the agency introduced the concept of an optional grace period for cafeteria plans, giving participants extra time after the plan year to incur qualifying expenses and draw down leftover balances. That guidance was formally incorporated into IRS bulletin, which confirmed that employers could extend the spending window by up to two months and 15 days past the plan year’s end. Any balance still remaining after the grace period, however, had to be forfeited under the same use-or-lose framework.
A second option arrived in 2013 when the IRS issued Notice 2013-71, allowing health FSA plans to let participants carry over up to $500 of unused funds into the next plan year. The Treasury Department explained the rationale in a Treasury release, noting that the carryover was designed to give employers and employees more flexibility. That same announcement stated a hard constraint: an FSA cannot have both a carryover option and a grace period. Employers must choose one or the other, or stick with the default forfeiture rule.
The carryover ceiling was later raised. IRS Notice 2020-33, published in Internal Revenue Bulletin 2020-22, increased the maximum carryover from the original flat $500 to an indexed amount equal to 20 percent of the annual health FSA salary-reduction limit. That change tied the carryover cap to inflation for the first time, meaning the dollar threshold adjusts each year alongside the contribution limit.
Compliance Limits That Shrink the Safety Net
Even when an employer adopts the carryover provision, the relief is not unlimited. IRS Notice 2015-87, published in Internal Revenue Bulletin 2015-52, addressed how carryover balances interact with COBRA continuation coverage rules. The Q&A guidance confirmed that prior-year carryover amounts can trigger separate COBRA obligations, adding administrative complexity for plan sponsors and potential confusion for departing employees who assume leftover funds simply roll forward without conditions.
The grace-period alternative carries its own constraints. Because the extra spending window applies only to expenses incurred during those additional weeks, participants who fail to schedule medical visits, fill prescriptions, or purchase eligible supplies before the extended deadline still lose whatever remains. Neither relief mechanism converts the FSA into a true savings vehicle; both simply widen the window before forfeiture applies.
Plan design choices can also narrow the benefit. Employers that want to minimize administrative burdens sometimes decline to offer either a grace period or a carryover, leaving workers fully exposed to the use-or-lose rule. Others adopt the carryover but keep employee communication minimal, so participants may not realize that modest balances can be preserved from one year to the next. In both cases, the practical effect is the same: employees who misjudge their annual health spending see their pretax contributions evaporate at year-end.
What Employees Can Do Before Year-End
Because the default rule is unforgiving, employees have strong incentives to monitor their accounts as December approaches. A first step is confirming whether the employer’s plan uses a grace period, a carryover, or neither. That information is typically outlined in the summary plan description or annual enrollment materials. If a grace period applies, workers can plan early-in-the-year appointments and eligible purchases to exhaust remaining funds. If the plan instead allows a carryover up to the indexed cap, participants may decide that a small leftover balance is acceptable while still avoiding larger forfeitures.
Employees should also review the list of qualifying medical expenses covered by the health FSA. Routine items such as prescription copays, certain over-the-counter drugs, and medical supplies can help close small gaps between current balances and year-end. For larger balances, scheduling preventive care visits, dental work, or vision services before the deadline may be necessary. The key is to treat the FSA as a reimbursement account tied to near-term expenses, not as a long-term savings strategy.
Why Employers Need Clear Communication
Employers that sponsor health FSAs bear the responsibility for implementing one of the permitted designs and communicating it clearly. Misunderstandings about grace periods, carryovers, and forfeiture can generate employee dissatisfaction even when the plan complies with IRS rules. Human resources teams may wish to send targeted reminders late in the year, explaining current balances, upcoming deadlines, and examples of eligible expenses.
When questions arise, employers and employees can consult the IRS directly or work with benefits advisers. The agency’s online assistance tools and published guidance provide technical details on cafeteria plan requirements, contribution limits, and the interaction of FSAs with other health coverage. Using those resources to verify plan terms can help reduce errors and avoid unexpected forfeitures at year-end.
