Flexible Spending Accounts (FSAs) are a powerful tool for employees to save on taxes while covering necessary health care and dependent-care expenses. However, unused balances in FSAs can be a source of confusion and even frustration for both employees and employers. Understanding what to do with forfeited FSA balances is critical, and working with a trusted McAllen CPA can help ensure your business stays compliant while maximizing financial efficiency.

Here’s a detailed breakdown of FSA basics, the “use-it-or-lose-it” rule, and employer options for handling unused balances.

Flexible Spending Account Basics

An employer-sponsored FSA allows employees to set aside a portion of their salary on a pre-tax basis to pay for qualifying expenses. Employees can contribute to:

• Health care FSAs, covering out-of-pocket medical costs like co-pays, prescription medications, dental care, vision care, and deductibles. For the 2025 tax year, the maximum contribution is $3,300 per employee, up from $3,200 in 2024.
• Dependent-care FSAs, covering expenses such as daycare, after-school programs, or eldercare services. The contribution limit is $5,000 per household. For married couples filing separately, the cap is $2,500 each.

Employee contributions are withheld in installments from each paycheck and treated as a pre-tax salary reduction for federal income, Social Security, Medicare, and often state taxes. Reimbursements for qualifying expenses are tax-free, effectively giving employees a combination of a tax deduction and reduced payroll taxes.

Put simply, FSAs let employees pay for essential costs with pre-tax dollars, permanently reducing their tax burden. For employers, FSAs can improve employee satisfaction and help attract and retain talent, but the administration of these accounts — particularly when money is left unused — requires careful management.

The Use-It-Or-Lose-It Rule

The primary downside of an FSA is the “use-it-or-lose-it” rule. If employees fail to spend their full FSA balance by the end of the plan year, the remaining funds generally revert to the employer. While it might seem like “free money” for the company, handling these forfeitures requires careful consideration.

There are two exceptions to the standard rule:

1. Grace Periods: Some FSA plans allow a grace period of up to 2.5 months after the plan year ends. For example, a calendar-year plan could allow employees until March 15 of the following year to spend their unused funds.
2. Carryover Options: Health care FSAs may permit employees to carry over up to $660 of unused funds into the next plan year. Note that a health care FSA plan cannot offer both a grace period and a carryover; it must choose one. Dependent-care FSAs can offer a grace period but cannot allow a carryover.

Understanding these options is crucial for employers to properly manage their FSA programs and to plan for how forfeited funds might be handled.

Employer Options for Forfeited FSA Balances

When FSA balances are forfeited under the use-it-or-lose-it rule, the IRS provides specific guidance on what employers can do. According to Treasury Proposed Regulation 1.125-5(o), employers have a few options:

1. Retain the Funds: Employers may simply keep forfeited amounts as a benefit of offering an FSA.
2. Use the Funds in Other Ways: If employers do not retain the money, forfeited balances can be used to:
   • Defray administrative costs of running the FSA or cafeteria plan.
   • Reduce employee contribution amounts for the following plan year on a reasonable and uniform basis.
   • Reimburse employees for claims in excess of their salary reduction contributions, if done fairly.
   • Return the funds to employees on a pro-rata basis, weighted according to their original contributions.

Here’s a practical example to illustrate:

Example: Handling Forfeited FSA Balances

Alpha Corporation maintains a cafeteria benefit plan for 1,200 employees, including a health care FSA. Employees can contribute in $100 increments, from a minimum of $660 to a maximum of $3,300. For the 2025 plan year, 1,000 employees participated. After the 2024 plan year, Alpha collected $5,000 in forfeited health care FSA balances.

Alpha has several options:

1. Keep the $5,000: This is straightforward and requires minimal administration.
2. Use the $5,000 to defray administrative costs: Paying for plan administration — such as processing reimbursements, compliance testing, or software fees — can be a practical use of forfeited funds.
3. Reduce next year’s employee contributions: Alpha could lower the cost of participation for all employees by a proportional amount. For example, a $500 contribution could be “priced” at $480, and a $1,000 contribution could be “priced” at $960.
4. Reimburse excess claims: The forfeited funds could cover health care FSA claims that exceed employees’ elected contributions, provided it’s done on a reasonable and uniform basis.
5. Return funds to employees on a weighted per-capita basis: For instance, an employee who contributed $1,000 would receive twice as much of the forfeited pool as an employee who contributed $500. Any returned amounts are treated as taxable wages for the year in which they are distributed.

Choosing the right approach requires careful planning and a clear understanding of tax and payroll implications. That’s where a McAllen CPA can provide critical guidance.

Why Working with a McAllen CPA Matters

Employers managing FSA plans need to balance compliance, fairness, and financial efficiency. A McAllen CPA can help by:

• Navigating IRS rules: Ensuring your FSA plan complies with use-it-or-lose-it rules, grace periods, and carryover provisions.
• Evaluating financial impact: Determining how forfeited funds affect your company’s finances, including potential administrative cost offsets or tax liabilities.
• Implementing fair strategies: Advising on how to return funds or reduce future contributions in a way that is equitable and compliant with regulations.
• Coordinating with payroll: Helping to ensure correct reporting of taxable wages if funds are returned to employees.

With professional guidance, employers can confidently manage forfeited FSA balances while maintaining positive employee relations and compliance with federal rules.

Practical Tips for Employers

Here are some actionable steps employers can take to make FSA management smoother:

1. Track FSA Usage Throughout the Year: Monitor employee claims and usage to anticipate forfeitures. Early insights allow you to plan administrative spending or employee contribution adjustments.
2. Communicate Clearly: Ensure employees know about the use-it-or-lose-it rule, grace periods, and carryover options. Clear communication can help reduce forfeited balances.
3. Plan for Administrative Costs: Consider using forfeited funds to cover the cost of administering the plan. A McAllen CPA can help quantify these expenses and ensure funds are applied correctly.
4. Evaluate Reimbursement Options: If reimbursing employees or reducing contributions, ensure the approach is reasonable and uniform to avoid compliance risks.
5. Document Everything: Keep clear records of how forfeited funds are handled, including any distributions or adjustments. Proper documentation protects your business in case of IRS audits.

 

FSA Forfeitures and Employee Relations

While forfeited FSA balances may seem like a windfall for employers, transparency and fairness are key. Employees appreciate clarity and consistency in how these funds are managed. If an employer simply keeps the forfeited money without explanation, it can create resentment. Using a McAllen CPA to guide policies ensures employees understand their options and that distributions or adjustments are handled equitably.

Properly managed, forfeited FSAs can be a tool to improve employee satisfaction, reduce administrative costs, and maintain compliance — all without creating unintended tax liabilities.

 

Final Thoughts

Flexible Spending Accounts provide substantial tax advantages to employees and enhance your overall benefits package. However, the use-it-or-lose-it rule and handling of forfeited balances require careful attention. With thoughtful planning, clear communication, and expert guidance from a McAllen CPA, employers can navigate these complexities while supporting both financial efficiency and positive employee relations.

If you’re an employer with an FSA program, or you’re considering implementing one, partnering with experienced professionals is invaluable. At Burton McCumber & Longoria, we help businesses in the McAllen area understand FSA rules, maximize benefits, and make informed decisions about forfeited balances and plan administration.

Contact Burton McCumber & Longoria today to speak with a trusted McAllen CPA who can guide your business through FSA administration and other employee benefits planning.