Last month, the IRS issued Notice 2005-42, which allows employers with a flexible benefits plan or Section 125 plan (frequently referred to as “cafeteria plans”) to provide a grace period before forfeiting any unused account balances at the end of the plan year.

Pursuant to the current “use it or lose it” rules, a cafeteria plan participant forfeits any unused money in his or her flexible spending account at the end of the plan year.  However, the IRS announced that it will allow employers to adopt a grace period of up to 2½ months for plan participants to incur expenses and use any remaining account balance.  The grace period is optional and requires an amendment of the underlying cafeteria plan document.  Employers will also need to develop internal systems to track and segregate cafeteria plan balances carried over for the grace period from those incurred toward the current year cafeteria plan account.

IRS Notice 2005-42 is available on the Internet at http://www.irs.gov/pub/irs-drop/n-05-42.pdf.