When it comes to FSA plans and participants that terminate coverage or employment mid-plan year, however, IRS "use-it-or-lose-it" rules have remained unchanged. Health care FSAs cannot cover expenses incurred after a participant's termination, unless the participant exercises a limited COBRA right. Once an individual is no longer an active employee, they are no longer active in the FSA. This means that any funds remaining in an FSA account at the time of termination, are subject to forfeiture.

Although most plans are designed to allow the submission of claims for up to 90 days following the termination date, the dates of service have to be on or before the termination date in order for the expenses to be eligible for reimbursement in an FSA. The exception to this rule, is when a former employee is eligible for and elects COBRA coverage for a healthcare FSA.. By electing COBRA, they will remain active in the benefit and can continue to use the funds in the account for dates of service incurred after their term date. This exception, however, is limited to healthcare FSAs only. Further, IRS rules require employers to include "use-it-or-lose-it" rules, and any permitted exceptions, within a FSA cafeteria plan document. However, there is no additional notice requirement when coverage is terminated midyear.

California AB 1554

On August 30, 2019, California enacted AB 1554. This state law requires employers who sponsor FSAs to notify California employees who participate in a FSA of any deadline to withdraw funds before the end of the plan year. AB 1554 applies to FSAs established to pay for eligible health care, dependent care, or adoption expenses. Employees must be notified by two different forms, only one of which can be electronic. Notice methods include e-mail, telephone, text message, postal mail or in-person notification.

Although the provisions of this law are fairly brief, it is fairly vague and raises significant questions about how to comply. AB 1554 appears to be aimed at notifying employees whose FSA coverage terminates during the plan year. However, the law does not specifically indicate that notice must be provided at termination of employment. In fact, the law does not indicate at all when the notification should be made, other than requiring the notice to be furnished in two different forms.

AB 1554 also fails to provide guidance on the content of the required notice. Since the intent of the new law is to warn terminated employees in the event they have to submit claims quickly to avoid forfeiture of their FSA, providing notice at the time of termination would seem especially important. However, since the law does not specify, it is unclear whether employers can decide to include this notice in their FSA plan document or other forms of annual communication.

ERISA preemption issue

The IRS is generally tasked with regulating FSA rules and enforcement. Because of this, it is easy for most employers to forget that healthcare FSAs are considered self-insured employee welfare benefit plans under the Employee Retirement Income Security Act (ERISA). As it pertains to health and welfare benefit plans, ERISA regulates the operation of employer-sponsored health coverage and plan administration. When ERISA was drafted in 1974, Congress inserted a clause into this historic legislation that specifically states that laws under ERISA will preempt all related state laws. This preemption mandate has, for the most part, been supported by federal Court precedent.

As California AB 1554 is a state law that impacts plan administration of healthcare FSAs, this new law should be preempted by ERISA. Accordingly, to the extent that this new law relates to health care FSAs, plan sponsors should not technically be required to comply. This of course would not be true for employers exempt from ERISA, such as local government and some church plans. However, even if ERISA preemption did not apply, the application of the new law to health care FSAs is very narrow and plan sponsors with participants in California may want to err on the side of caution and make good faith efforts to comply with its requirements.

As California AB 1554 does not include any specific enforcement provisions, such as penalties or fines, it is unclear how the state will enforce this new law. Considering the law's vague provisions and potential ERISA preemption implications for healthcare FSAs, any attempts at enforcement would likely be met with challenges. However, as California state has traditionally been reluctant to recognize ERISA preemption without an applicable court ruling, it may be easier for employers to simply comply, at least for the time being. Philip Qualo, J.D., joined the The Phia Group, LLC in June 2018. In his current role as a compliance and regulatory affairs consultant, Philip provides consulting services to employers, third-party administrators, brokers, and vendors on an array of topics focused human resource and employee health benefit plan compliance. He proactively monitors the legal and regulatory environment to identify legal, regulatory and compliance-related gaps and advises internal and external stakeholders on areas of risks.

Read more: 

• HSA/FSA facts for open enrollment
• Keeping up with the Joneses: Employer trends in HRA, FSA, & HSA
• 8 health savings account headaches — and their solutions