Flexible Spending Accounts (FSAs) remain one of the most popular tax-advantaged benefits employers can offer. FSAs allow employees to pay for eligible healthcare expenses with pre-tax dollars, reducing payroll taxes for both employees and employers while helping participants manage healthcare costs more effectively.

One of the most important FSA plan design decisions employers must make involves addressing the FSA “use-it-or-lose-it” rule. Under IRS regulations, unused FSA funds are generally forfeited at the end of the plan year. To provide additional flexibility, employers may choose to offer either a grace period or a carryover provision, but not both.

Understanding the differences between these options can help employers build a more employee-friendly benefits program while minimizing confusion and forfeitures.

Understanding the FSA Use-It-or-Lose-It Rule

Healthcare FSAs operate under IRS rules that generally require unused funds to be forfeited when they are not spent within the applicable timeframe. Because FSAs provide significant tax advantages, they are not intended to function as long-term savings vehicles.

To help employees retain access to unused funds, the IRS allows employers to adopt one of two optional plan features:

  • A grace period
  • A carryover provision

Employers may choose either option or neither option, depending on their workforce needs and benefits strategy.

What Is an FSA Grace Period?

A grace period provides employees with additional time after the end of the plan year to incur eligible healthcare expenses using their prior-year FSA balance.

The IRS permits employers to offer a grace period of up to 2½ months following the close of the plan year. For calendar-year plans, this typically extends through March 15 of the following year.

How an FSA Grace Period Works

Suppose an employee finishes the plan year with $300 remaining in their healthcare FSA.

If the organization offers a grace period, the employee has until March 15 to incur eligible healthcare expenses and use the remaining balance from the prior plan year. This extended timeframe allows employees additional opportunities to use unused funds on qualified expenses before they are forfeited under IRS rules.

From an employer perspective, offering a grace period can help reduce employee forfeitures, enhance the perceived value of the FSA benefit, and lessen employee frustration associated with year-end unused balances. It may be particularly beneficial for workforces that commonly incur healthcare expenses during the first few months of the year.

Advantages of Offering a Grace Period

  • Provides employees with additional time to use remaining funds.
  • Helps employees who schedule medical, dental, or vision services early in the year.
  • May reduce year-end spending rushes.
  • Supports employees with predictable healthcare spending patterns.

Potential Drawbacks

  • Employees must track multiple deadlines.
  • Administrative communications may become more complex.
  • Unused funds are still forfeited once the grace period ends.
  • Employees may confuse claim submission deadlines with expense-incurrence deadlines.

When a Grace Period May Make Sense

A grace period may be a strong fit if employees:

  • Regularly incur healthcare expenses during January and February.
  • Schedule annual medical procedures early in the year.
  • Prefer additional time to use prior-year balances.
  • Tend to have predictable healthcare spending patterns.

What Is an FSA Carryover?

A carryover provision allows employees to move a limited amount of unused healthcare FSA funds into the next plan year. The IRS permits healthcare FSA carryovers up to an annually indexed maximum amount.

Employers may choose to allow the maximum permitted carryover or establish a lower amount within their plan design. Because the allowable carryover amount is subject to change, employers should review current IRS limits when evaluating their FSA plan design.

Unlike a grace period, employees do not need to spend the carried-over funds during a short extension window. Instead, the carryover amount remains available throughout the following plan year.

How an FSA Carryover Works

If an employee ends the plan year with $500 remaining in their healthcare FSA and the employer’s plan permits at least that amount to be carried over, the $500 may be transferred into the following plan year.

This allows the employee to start the new year with additional tax-advantaged funds available for eligible healthcare expenses. As a result, employees may feel more confident making FSA elections during open enrollment, knowing that a portion of unused funds may remain available for future use.

Advantages of Offering a Carryover

  • Provides flexibility throughout the entire following plan year.
  • Reduces employee concerns about forfeiting funds.
  • May encourage participation and larger elections.
  • Simplifies employee financial planning.

Potential Drawbacks

  • Carryovers are limited to the IRS-approved maximum or a lower amount established by the employer’s plan.
  • Balances exceeding the allowable carryover limit are generally forfeited.
  • Carryover rules do not apply to every type of FSA.
  • Employees may need education regarding annual limits and eligibility rules.

When a Carryover May Make Sense

A carryover may be preferable if employees:

  • Value flexibility throughout the entire year.
  • Frequently overestimate annual healthcare expenses.
  • Have unpredictable healthcare spending needs.
  • Express concerns about forfeiting FSA dollars.

Many employers find that carryovers are easier for employees to understand and use, which may lead to higher employee satisfaction and improved participation.

Grace Period vs. Carryover: Side-by-Side Comparison

Feature Grace Period Carryover
How It Works Extends time to incur expenses Moves a limited amount of unused funds into the next year
Length of Availability Up to 2½ months Entire following plan year
IRS Limit Time-based Dollar-based and indexed annually
Employee Flexibility Limited extension period Full-year flexibility
Administrative Complexity Moderate Generally lower
Best For Predictable early-year healthcare spending Long-term flexibility and participation
Can Employers Offer Both? No No

Employers must choose one option or neither. IRS rules do not permit a healthcare FSA to offer both a grace period and a carryover provision for the same plan year.

Review FSA Plan Data Annually

There is no universal answer regarding which design is better. Employers should evaluate workforce demographics, historical claims activity, participation trends, and employee feedback before deciding.

Questions employers should consider include:

  • Do employees frequently forfeit unused balances?
  • Are healthcare expenses concentrated early in the calendar year?
  • Do employees express concerns about losing unused FSA dollars?
  • Is increasing FSA participation a strategic goal?
  • Would a simpler plan design improve employee understanding?

Reviewing historical utilization data and employee feedback can provide valuable insights into which option best aligns with workforce needs.

Employers should also analyze participation levels, average election amounts, and forfeiture trends each year to ensure their current plan design remains effective.

Ongoing FSA Education and Mid-Year and Year-End Reminders

Educating employees on realistic healthcare spending projections can help reduce forfeitures while maintaining the tax advantages FSAs provide.

To help employees maximize their benefits and reduce forfeitures, employers should provide ongoing education rather than limiting FSA communications to open enrollment. Consider mid-year reminders, year-end notices, and educational resources throughout the year.

Many employees may also be unaware of the wide range of expenses that can qualify for reimbursement, including:

  • Prescription medications
  • Dental services
  • Orthodontia
  • Eye exams
  • Contact lenses
  • Medical supplies and equipment

Choosing the Right FSA Design for Your Organization

Choosing between a grace period and a carryover provision is an important FSA plan design decision. Both options can help reduce employee forfeitures, improve the overall value of the benefit, and enhance employee satisfaction.

The best approach is to evaluate your employee population, review historical utilization patterns, and select the design that aligns with your organization’s benefits strategy. A thoughtful FSA design can improve employee engagement, increase participation, and help employees maximize the value of their pre-tax healthcare dollars.

Working with an experienced Benefits Administrator can make this process significantly easier. From plan design consultation and compliance support to employee education and ongoing administration, Flyte HCM helps employers implement and administer FSA solutions that align with workforce needs, reduce administrative burdens, and enhance the overall benefits experience.

Ready to Review Your FSA Strategy?

Whether you’re implementing a new Flexible Spending Account or reviewing your existing plan design, Flyte HCM can help you evaluate your options and determine an approach that works for your organization and employees.

Ready to learn more? Connect with the Flyte HCM team today to discuss your FSA administration needs.