Many companies offer flexible spending accounts (FSAs) for health care and dependent care as part of their employee benefits programs. These plans allow employees to save on taxes while also providing payroll tax savings for employers.
If your organization runs a calendar-year FSA plan with a 2½-month grace period, employees typically have until March 15 to incur eligible expenses using their 2025 balances. Any unused funds remaining after that deadline may be forfeited under the well-known “use-it-or-lose-it” rule.
Below is a refresher on how FSAs operate and what employers are allowed to do with forfeited balances.
How Flexible Spending Accounts Work
Under an employer-sponsored FSA plan, employees can set aside a portion of their salary on a pretax basis into one of two common accounts.
Health Care FSA
A health care FSA allows employees to pay for eligible out-of-pocket medical expenses for themselves, their spouses, or qualified dependents. Covered costs may include medical, dental, and vision care expenses.
For 2026, the maximum employee contribution rises to $3,400, up from $3,300 in 2025. This limit is adjusted annually for inflation.
Dependent Care FSA
Dependent care FSAs are used for eligible childcare or adult dependent care expenses that enable employees to work.
Beginning in 2026, recent tax legislation increased the contribution limit to $7,500 per household or $3,750 for married taxpayers filing separately. The 2025 limit was $5,000 (or $2,500 for separate filers).
Unlike the health care FSA limit, the dependent care limit is not indexed for inflation, meaning it will remain unchanged unless future legislation increases it.
Tax Advantages
Employee contributions to FSAs are made before taxes, which lowers taxable income for:
- Federal income tax
- Social Security tax
- Medicare tax
- Often state income tax
The plan then pays or reimburses qualified expenses tax-free.
Understanding the Use-It-or-Lose-It Rule
If employees don’t spend all the money in their FSA by the end of the plan year, the remaining balance generally reverts to the employer. This rule is commonly known as use-it-or-lose-it.
However, employers can offer certain exceptions.
Grace Period Option
Employers may allow a grace period of up to 2½ months following the end of the plan year. For calendar-year plans, this means employees can incur eligible expenses until March 15 of the following year using the prior year’s funds.
Carryover Option (Health Care FSA Only)
Health care FSA plans may allow employees to carry over a limited amount of unused funds to the next plan year.
For example:
- Up to $660 could be carried over from 2025 to 2026
- Up to $680 can be carried over from 2026 to 2027
Employers should note that a health care FSA can provide either a carryover or a grace period — but not both.
Dependent care FSAs are limited to the grace period option only and cannot offer a carryover feature.
What Employers Can Do With Forfeited FSA Funds
After the grace period ends or any allowed carryover is applied, any remaining unused balances become forfeited. Under IRS cafeteria plan rules, employers may keep these funds.
A common use for forfeited balances is to cover plan administration costs.
Other permitted options include:
Reducing Future Employee Contributions
Employers may apply forfeited funds to lower the amount employees need to contribute to reach a certain FSA balance in a future year.
For example, employees may contribute $950 to receive a $1,000 FSA balance, with the remaining $50 funded by prior forfeitures.
Returning Funds to Participants
Businesses may also return some forfeited funds to employees. In most cases, these payments must be treated as taxable wages, meaning they are subject to payroll taxes and income tax withholding.
Important Compliance Rules
When redistributing forfeited funds, employers must follow strict guidelines.
For example:
- Funds cannot be returned based on an employee’s individual claims experience
- Any distribution must be reasonable and uniform
- Allocations must comply with plan documentation and nondiscrimination rules
Failing to follow these rules could jeopardize the tax-advantaged status of the FSA plan.
A Good Time to Review Your FSA Plan
The period around the grace-period deadline can serve as a useful checkpoint for employers. It’s an opportunity to evaluate how unused balances are handled and ensure the plan structure still meets both employee needs and administrative requirements.
Reviewing plan provisions—such as grace periods, carryover rules, and forfeiture handling—can also help businesses prepare for the next benefits enrollment cycle.
Professional guidance can help ensure forfeitures are managed correctly and that plan terms remain compliant with current regulations.
© 2026