Vol. 46, No. 1
Final IRS regulations, which take effect this month, clarify when employees can make mid-year changes to cafeteria plans.
New rules from the Internal Revenue Service (IRS) should make it easier and less confusing for employees to make mid-year changes to cafeteria benefit plans. The rules, adopted by the Internal Revenue Service in March 2000 after years of review, apply to all types of Section 125 benefits plans that begin on or after Jan. 1, 2001.
The new final rules update temporary regulations issued in 1997 that specify when employees are allowed to make mid-year changes.
For tax reasons, the IRS generally allows changes to be made to cafeteria plans only during open enrollment—the period preceding the start of a new plan year. After the start of the plan year, changes can be made only if the conditions that prompted them fall within certain specified exceptions. The temporary regulations gave examples of who could make such changes and when, but cafeteria-plan administrators still found many gray areas.
"There were many questions," says Sharon Cohen, a former IRS attorney who is counsel to consulting firm Watson Wyatt’s group health care practice. "One of the areas with the most questions was ‘When can participants change their elections?’ "
IRS spokesman Anthony Burke adds that the temporary rules spurred "a demand for greater specificity."
And that’s exactly what the final regulations provide—a clearer explanation of the events that qualify for mid-year changes. In some ways, the regulations also expand on these exemptions, giving employees greater freedom to make changes. In other ways, the final regs impose more limitations on employees’ ability to make mid-year changes. But in the end, perhaps the greatest benefit of these rules is that they provide clarity.
The final rules are "much more thought-through and reflective of real life," says Mary Case, a principal in Unifi Network, PricewaterhouseCoopers’ HR and benefits consulting arm. They list specific "change-in-status" events that can prompt mid-year election changes in cafeteria plans. (The IRS also has published related, temporary rules about dependent care, adoption assistance and changes in benefit cost and coverage, which employers also can rely on.)
The new rules also make Section 125, the part of the Internal Revenue Code that governs cafeteria plans and other flexible benefit plans, consistent with the Health Insurance Portability and Accountability Act of 1997. (HR professionals should note that 401(k) plans offered through cafeteria plans are subject to different IRS rules.)
Whether or not employees can take advantage of mid-year changes is entirely up to you. Employers can make some, all or none of the changes permitted by the rules. "The employer can’t be more permissive than the IRS, but it can be less permissive," says Gary B. Kushner, SPHR, president of Kushner & Company, an employee benefits consulting firm based in Kalamazoo, Mich.
Adopting the changes, however, "makes employees’ lives so much easier," says Cohen, and it also can reduce costs and annoyance for your workers.
Change in Status Rules
People don’t time their lives according to their cafeteria plans. They get married, have children, divorce and change jobs throughout the year. While the IRS long has allowed mid-year changes based on such "change-in-status" events, its new rules are more specific about what types of events qualify.
"There are more things on the list, but it’s an exclusive list," says Vollmar. According to Willis’s analysis of the IRS rules, there are seven changes in status that can prompt mid-year election changes.
The only new change is the start or end of an adoption proceeding, as it applies to adoption-assistance elections.
In addition, the "change in employment status" category has been broadened to include more events, such as starting or ending an unpaid leave of absence, as long as they affect plan eligibility, according to information from Watson Wyatt.
The only change in status that is more restrictive than before pertains to moving. Previously, when employees (or spouses or dependents) moved out of a health plan’s service area, they could switch health plans or drop coverage. Now they can only switch plans, according to a Watson Wyatt analysis.
The new rules also clarify what takes place when an employee is terminated and rehired shortly afterward. If the rehire occurs within 30 days, a cafeteria plan automatically reinstates an employee’s elections. If the rehire occurs after 30 days, the employee can make new elections if desired.
Under the IRS rules, employees can make mid-year election changes only if they are "on account of and corresponding with" a qualified change in status. In general, these consistency rules are clearer—albeit stricter—than before, analysts say.
Here’s an example: An employee and his entire family are covered under his employer’s health plan. The employee gets divorced. The change in his status allows him to make a mid-year change. But he can drop only his wife, not his children, from the health plan because the divorce affects only his marriage, not his relationship with his children.
Under the final rules, the IRS did liberalize its view of group-term life insurance.
Previously, if a spouse died, employees could only decrease coverage. Now employees also can increase coverage, which recognizes the fact that single parents who are the sole providers for their families may want more, not less, of this benefit, Cohen says.
Also expanded are the mid-year elections allowed for changes in cafeteria plan cost or coverage levels. Previously, such changes were possible only if an independent third-party, such as an insurance company, made the changes. Now the rules also apply to employers with self-funded health plans. (However, they don’t apply to medical flexible spending accounts.)
For example, if health insurance premiums rise, employers automatically can change workers’ contribution levels, but employees can’t drop coverage. If a cost increase is "significant"—a term the IRS does not define—employees can increase their contributions or switch to another health plan.
Another positive change is that if dependent-care costs rise or fall, employees can adjust their contributions mid-year. For instance, an employee whose baby starts day care can begin pretax contributions to pay for that care right away, instead of waiting for a new plan year to begin. However, no change is allowed if the care is provided by a relative. Previous IRS rules on this topic were unclear, experts say.
One change employers may not want to permit involves working spouses who are covered by separate Section 125 plans with different open enrollments. The IRS allows one spouse to make a change if the other does as well. For example, if a wife drops out of her employer’s health plan, a husband can add her to his employer’s health plan mid-year. The rule was meant to help workers fill gaps in coverage or avoid duplicate coverage.
The problem, said Vollmar, is that many health plans don’t allow mid-year additions. This fact, along with the higher volume and cost of adding enrollees, makes this particular change unattractive to employers, she says. For employees, it could result in either no or duplicate benefit coverage for a period of time, she adds.
Complying with the Rules
There are several steps human resources managers can take to implement the IRS rules. The first step is to read the regulations and decide which, if any, to adopt. Then amend written cafeteria plan documents, including summary plan descriptions given to employees, to reflect the changes you want. Also, inform third-party administrators if necessary.
Beware of catch-all phrases that say something like, "This cafeteria plan allows any election changes permitted by the IRS," warns Vollmar. If your old plan contains such a phrase and you’re not adopting all of the new rules, take it out.
Plans can be redrafted after the plan year begins, but employers that decide to adopt any changes must comply operationally, said Michele Lellouche, assistant general counsel at SunGard Corbel Inc., of Jacksonville, Fla., which develops software and other materials on how to administer retirement plans. For HR, this step means becoming well versed in the new rules’ intricate "if, then" scenarios.
"It’s important for that body of knowledge to be in the HR department," says Lane Transou, SPHR, director of benefits and compensation for Toshiba International Corp., a Houston-based manufacturer of industrial electrical systems. Transou talked to lawyers and drew up a matrix for HR staff to use when answering employees’ questions.
Employers should require employees with a change in status to make corresponding cafeteria-plan election changes within 60 days to avoid an IRS challenge, Willis notes in an analysis. In practice, many plans limit this window of opportunity to 30 or 31 days.
HR managers also should inform their employees—by memo, e-mail or brochure—of the new rules before they are implemented. But keep it simple, experts advise. It’s OK to explain that mid-year plan changes are possible in the event of a marriage, birth or other major life event, then tell employees to see HR when the event actually occurs.
It’s too confusing for workers to be bogged down with the details of the new rules, HR managers say. "The time they come in for counseling is when they need to know. Then we sit down and talk to them," Transou says.
Carolyn Hirschman is a business writer based in Rockville, Md. She has written for a variety of business publications and has covered workplace issues since 1991.