When H. G. Wells wrote The Time Machine in 1895, he struck a chord with mankind’s dream of going back in time. Interestingly, some employees may have the same dream regarding health and welfare benefits, in the form of retroactive elections.
Like the Wells masterpiece, though, an employer’s ability to allow retroactive pretax elections is a work of fiction—for the most part. The general rule is such elections cannot be done. This sometimes comes as a surprise to employees as well as some well-meaning HR and benefits professionals.
But the general rule is only the beginning of the story. Some plot twists exist, such as exceptions that are based on statute or regulations, another commonly accepted exception, several permissible workarounds, and the implications of what I call the Divorce Dilemma.
The General Rule
Cafeteria plans allow employees to pay for qualified benefits on a pretax basis. There is a trade-off, however. Once an election is made, it is irrevocable. Limited circumstances justify changing that election, primarily itemized in regulations that remain unchanged since 2001; examples include change in status events, Medicare enrollment and loss of Medicaid or CHIP coverage. If an election change is allowed, it generally must take effect prospectively. In other words, you cannot go back in time.
The regulations provide a good example of the prospective election rule:
(i) …Before the beginning of the calendar year, Employee E elects employee-only health coverage under M’s cafeteria plan. Employee E marries F during the plan year. F’s employer, N, offers health coverage to N’s employees, and, prior to the marriage, F had elected employee-only coverage. Employee E wants to revoke the election for employee-only coverage under M’s cafeteria plan, and is considering electing family health coverage under M’s plan or obtaining family health coverage under N’s plan.
(ii) M’s cafeteria plan may permit E to change E’s salary reduction election to reflect the change to family coverage under M’s accident or health plan because the marriage would result in special enrollment rights under section 9801(f)… Since no retroactive coverage is required in the event of marriage under section 9801(f), E’s salary reduction election may only be changed on a prospective basis.
Let’s be clear. The prospective election requirement only applies to pretax benefits through a cafeteria plan. Post-tax benefits can be elected on a retroactive basis. A word of caution: Most post-tax benefits are fully insured (for example, group term life, long-term disability, accidental death, and dismemberment) so an employer should check with the insurance carrier to confirm the election rules.
The example above points to three of the four regulatory exceptions to the general rule. They are found in Internal Revenue Code Section 9801(f), which is a portability rule in the Health Insurance Portability and Accountability Act (HIPAA). In other words, elections based on these events can be made on a retroactive basis: birth, adoption, placement for adoption of a child. Why? Because HIPAA requires group health plans to provide retroactive enrollment when an employee notifies the plan within at least 30 days of the event. The cafeteria plan regulations simply align the pretax payment for that retroactive coverage.
Recall that—except in the rarest of cases—health flexible spending accounts (FSAs) are considered HIPAA-excepted benefits. As a result, the above three exceptions do not apply to health FSAs. Also, the above three exceptions apply only to group health plans; thus, the exceptions do not apply to dependent care FSAs.
The fourth exception is found in the 2007 proposed cafeteria plan regulations. A 30-day window exists for new hires in which the election may take retroactive effect. To be clear, this is limited to the first 30 days of employment, not the first 30 days of eligibility and not the first 30 days after a waiting period ends.
So does the fourth exception apply to health and dependent care FSAs? The answer is not clear. On the one hand, the language in the regulations appears to apply to all pretax qualified benefits. On the other hand, language elsewhere in those same regulations limits health and dependent care FSA reimbursements to those incurred during the coverage period that starts on “the date the employee is enrolled” for coverage.
The Commonly Accepted Exception: The Mistake of Fact
Correcting elections based on mistakes of fact has become a standard practice after Internal Revenue Service (IRS) officials informally commented that an incorrect election can be corrected when there is clear and convincing evidence of the mistake. The correction should put the employee in the same position as if the mistake had never been made. The result often amounts to a retroactive election.
What kinds of mistakes can be made based on clear and convincing evidence? One example would be an employee with no children making a $2,650 dependent care FSA election for 2018. Few would argue against the assertion that the employee mistakenly made a dependent care FSA election when what was intended was a health FSA election. This applies an impossibility standard where the employee could not have benefited from the mistake. This is more defensible with the IRS.
Another example is employer error where the enrollment system simply makes the wrong election. For example, a system glitch might have cleared out an employee’s election for family dental coverage, an omission that the employee may not notice for several months until the first round of checkups for the year. In that case, a retroactive election change—with the corresponding back pretax payments—seems entirely reasonable. This applies a facts-and-circumstances standard where the situation suggests a mistake was made. This may be harder to defend with the IRS.
Keep in mind that mistake of fact is not found in any statute, regulations, or other official binding guidance that relates to cafeteria plan elections. Recall also that the 2007 proposed cafeteria plan regulations contain a list of operational failures that can jeopardize the tax-favored status of all pretax benefits for all participants. Violating the election change rules is one of those operational failures.
Therefore, mistake of fact should be used sparingly. It is not a magic wand.
Assuming none of the exceptions apply, several alternatives exist to the general rule, which prohibits retroactive pretax elections:
- You can allow the election to take effect retroactively and allow employees to pay for the retroactive period on a post-tax basis. Post-tax payments take the coverage for that period outside of the Code Section 125 cafeteria plan rules all together.
- An employer can simply waive payment for the retroactive period. Again, Code Section 125 focuses on pretax payment of benefits. Having no payment for benefits again takes the retroactive period outside of the cafeteria plan rules.
- An employer can encourage employees to make anticipatory (a.k.a. springing) elections. Take the marriage event. Before the employee leaves for the wedding, the employee could make an election that takes effect on the wedding day, which at that point in time is a future event. The employee is making a prospective election. Contrast that with the employee who waits to make the election after the honeymoon and wants the election to take effect on that same day. Now, the employee is making a retroactive election. That will not do. As a practical matter, many election change events can be anticipated (for example, loss of Medicaid or CHIP, Medicare entitlement, even a spouse gaining employment).
- Employers have some flexibility when it comes to annual open enrollment. Let’s consider a calendar plan year where the open enrollment period is the first 2 weeks of November. Several employees wrongly assume that their current elections will automatically apply to the next plan year as they have in the past. Instead, this year the employer is requiring affirmative elections (perhaps, due to some major plan design changes). After open enrollment ends, the employer sends out election confirmations, and the do-nothing employees are surprised at what those statements say. Can the employer allow them to make an election?
Yes. The employer can do this, as long as the elections remain prospective. In this case, election changes can occur right up to the last day before the plan year begins (December 31). This is sometimes called the “silent” enrollment period. There are some precautions, though:
- You want to make sure that the cafeteria plan document or any other communications do not prohibit this practice.
- To be fair, you should let everyone know that this right exists.
- If you are going to allow a silent enrollment period, an employer is within its right to limit its application. For example, you could limit it to medical plan elections and to those who did not previously elect.
The Divorce Dilemma
Divorces are often difficult, and they can present a special conundrum in benefits administration where four different rules—two under the Tax Code, one under the Affordable Care Act (ACA) and one under the Employee Retirement Income Security Act (ERISA)—sometimes conflict. Here is a common scenario:
The benefits professional overhears an employer talking about his honeymoon in a tropical resort after his second marriage. You approach the employee and point out that he never informed the plan of his first divorce, reminding him that his ex-wife is still covered under the plan. He says that he had to do that because of the divorce decree.
Let’s put aside three side issues before we address the conflict in the rules:
- Whether the employee can add the second wife. That is a change in status event, and he can do it on a prospective basis if he notifies the plan within the proper period of time (typically 30 days after the event).
- Whether the employer must offer the ex-wife continuation coverage under the Consolidated Omnibus Budget Reconciliation Act (COBRA). Assuming the employee and ex-wife had notice of the qualifying event reasonable notification procedures (for example, through a COBRA general notice), they had to notify the plan within 60 days of the event. Failure to do so eliminates an employer’s COBRA obligation to the ex-wife.
- What the employee should have done: Notify the plan of the divorce and pay for his ex-wife’s COBRA or similar individual coverage as mandated by the divorce decree.
Now, let’s get to the conflict. When do you terminate the ex-wife’s coverage? Do you do it prospectively on the date of the conversation with the employee or retroactively to the divorce date? Let’s line up the four rules:
- The cafeteria plan election rules say that the election change must be prospective because it does not fit one of the statutory/regulatory exceptions. Mistake of fact does not apply because the employee intended to keep the ex-wife on the plan. Those rules would indicate that you terminate coverage prospectively.
- The tax dependent rules say that only spouses and other tax dependents can have pretax benefit coverage. An ex-wife is neither one of those. Those rules would indicate that you terminate coverage retroactively, refunding any difference in employee contribution to the employee on a taxable basis.
- The ACA rescission of coverage rules say that a group health plan cannot retroactively terminate coverage except in cases where the individual engaged in fraud or intentional misrepresentation of a material fact. While the employee arguably engaged in fraud/misrepresentation, it is the ex-wife’s coverage that would be terminated, and she would appear to be innocent of that misdeed. Those rules would indicate that you terminate coverage prospectively.
- The ERISA fiduciary rules say that a plan must be managed according to the terms and conditions in the written plan document, which undoubtedly would state that a spouse loses eligibility upon divorce. Those rules would indicate that you terminate coverage retroactively and seek reimbursement from the employee for any paid claims during that time.
So what do you do about the effective date of the election change? Two laws say prospective termination, two laws say retroactive termination. The consequence of violating the first two rules is a potential plan disqualification due to an operational failure. The consequence of violating the ACA rule is a potential $100 daily excise tax. The consequence of violating the ERISA rule is a potential fiduciary breach and the related damages.
One could design the cafeteria plan document to allow for an automatic election change whenever an employer discovers facts that make a dependent ineligible, effective on the date that the circumstance changed (that is, a divorce).
The bottom line is that depending on the employer’s culture and point of view, either approach could be reasonably justified.
In summary, retroactive elections are generally prohibited, but the specific exceptions and other considerations make this a complicated issue for pretax, employer-provided benefits.
|Rich Glass is a health and welfare attorney for Mercer Health & Benefits LLC. He is a licensed attorney and brings more than 24 years of legal expertise, specializing in benefits, Human Resources and related regulatory compliance. He has testified before the IRS and has provided comments on regulations issued by several governmental authorities. He is a contributing editor of BLR’s Flex Plan Handbook. He is a frequent speaker and author on various benefits, employment law, and compliance issues.|