FSA Grace Period vs Carryover: Employer Options

Employers sponsoring health care Flexible Spending Accounts face a structural choice in plan design: whether to offer account holders a grace period extension, a year-end carryover, or neither. These two provisions govern what happens to unspent FSA funds at the close of a plan year, and the decision carries meaningful tax, administrative, and employee retention implications. Understanding how each option operates under Internal Revenue Service rules helps plan sponsors design FSA features that align with workforce needs and compliance requirements.

Definition and Scope

The baseline FSA rule, often called the use-it-or-lose-it rule, requires that funds contributed to a health care FSA be forfeited if not used for qualified expenses by the plan year's end. This default arises from IRS rules under Internal Revenue Code Section 125, which governs cafeteria plans and their FSA components. The IRS has issued two formal modifications to this default through published guidance — IRS Notice 2005-42, which introduced the grace period, and IRS Notice 2013-71, which introduced the carryover. Employers may adopt one of these modifications, but not both simultaneously for the same FSA benefit type within the same plan year. The /regulatory-context-for-health-savings section of this resource covers the broader statutory framework in which these elections operate.

The scope of these provisions applies primarily to general-purpose health care FSAs and limited-purpose FSAs. Dependent care FSAs are governed by a separate statutory framework under IRC Section 129 and are not eligible for the carryover provision; the grace period, however, may apply to dependent care FSAs under certain plan designs.

How It Works

The Grace Period

Under IRS Notice 2005-42, a plan may permit participants to incur eligible expenses for up to 2.5 months after the close of the plan year and charge those expenses against prior-year FSA balances. For a calendar-year plan ending December 31, the grace period extends through March 15 of the following year. Expenses incurred during this window are treated as if incurred during the prior plan year for reimbursement purposes.

The grace period applies to the entire unused balance — there is no dollar cap on the amount that can roll into the grace period window. A participant with $1,200 remaining on December 31 may apply that full balance against expenses incurred through March 15.

The Carryover

IRS Notice 2013-71 established the carryover alternative. Under this provision, participants may carry a specified dollar amount of unused funds into the next plan year without forfeiture. The IRS adjusts this cap annually. For plan year 2024, the maximum carryover amount is $640 (IRS Revenue Procedure 2023-34). Funds carried over are available for the full next plan year rather than only a short extension window.

Unlike the grace period, the carryover is capped. Any unused balance exceeding the $640 threshold at year-end is still subject to forfeiture under the use-it-or-lose-it rule. Carried-over funds count toward the annual limit calculation under certain plan designs, so plan sponsors must review their plan document language carefully.

Structural Comparison

Feature Grace Period Carryover
Duration of relief 2.5 months post-plan-year Full following plan year
Dollar cap None $640 (2024)
HSA compatibility Disqualifies HSA eligibility unless limited-purpose Compatible if plan uses limited-purpose FSA
IRS authority Notice 2005-42 Notice 2013-71
Can both be offered? No — mutually exclusive No — mutually exclusive

Common Scenarios

Scenario 1: High-Balance Enrollees Near Year-End
A participant who contributed $3,050 (the 2024 maximum per IRS Revenue Procedure 2023-34) and has $1,800 remaining in late December faces different outcomes depending on the plan feature. Under a grace period plan, the full $1,800 is available through March 15 to cover expenses. Under a carryover plan, $640 carries forward and $1,160 is forfeited.

Scenario 2: HSA Transition Planning
An employer offering a general-purpose FSA with a grace period creates an HSA eligibility problem. An employee who wants to open or contribute to an HSA in January cannot do so while a general-purpose FSA grace period is active, even if the FSA balance is zero. The grace period keeps the employee "enrolled" in the FSA for purposes of IRC Section 223. Employers transitioning their workforce toward High Deductible Health Plan designs paired with HSAs frequently switch from the grace period to the carryover, or adopt a limited-purpose FSA structure, to eliminate this conflict.

Scenario 3: Neither Option Elected
An employer may elect neither modification, maintaining the strict use-it-or-lose-it rule. This simplifies plan administration and maximizes the forfeiture pool — forfeited amounts may be used by the employer to offset plan administration costs or redistributed pro rata among participants, subject to plan document terms.

Decision Boundaries

Employers evaluating these options apply the following structured framework:

  1. Review HSA strategy alignment. If the employer's benefit design includes or plans to include HSA-qualified High Deductible Health Plans, carryover (or the limited-purpose FSA structure) is typically the compatible choice. Grace periods block HSA contributions for participants who have any remaining general-purpose FSA balance on the last day of a month.

  2. Assess workforce spending patterns. Payroll and benefits data showing average FSA forfeitures under current plan design can indicate whether a carryover or grace period better addresses participant loss. Workforces with high year-end balances may benefit more from a grace period's unlimited rollover window; workforces with moderate predictable balances may prefer the carryover's year-round access.

  3. Review administrative capacity. The grace period extends claims processing into the following year, requiring the third-party administrator to maintain two plan-year balances simultaneously through mid-March. Some administrators charge additional fees for this operational window.

  4. Confirm plan document and summary plan description language. Either modification must be reflected in a formal plan amendment before the plan year it applies to, consistent with IRS guidance. The IRS rules governing FSAs establish specific timing requirements for plan amendments adopting or removing these features.

  5. Consider the interaction with COVID-19 relief provisions. The Consolidated Appropriations Act of 2021 temporarily permitted employers to allow unlimited FSA carryovers and extended grace periods for plan years 2020 and 2021. Employers who adopted those temporary expansions must confirm whether their plan documents reverted to IRS-standard limits for subsequent years.

The National Health Savings Authority home resource provides further context on how FSA plan design connects to the broader landscape of tax-advantaged health account structures available under current federal law.

References

The law belongs to the people. Georgia v. Public.Resource.Org, 590 U.S. (2020)