Benefits Buzz

IRS Clarifies Dependent Care FSA Rules

Posted on May 18th, 2021

The Internal Revenue Service (IRS) has recently issued Notice 2021-26 which provides tax guidance for various provisions that have recently changed for Dependent Care Flexible Spending Accounts (DC FSAs), which are sometimes also referred to as Dependent Care Assistance Programs (DCAPs).

Background

The Consolidated Appropriations Act of 2021 optionally and temporarily allows employers to amend their DC FSA to provide an unlimited carryover of unused funds to the following plan year. Unused funds from the 2020 plan year can be carried over to the 2021 plan year, and unused funds from the 2021 plan year can be carried over to the 2022 plan year.

Alternatively, an employer may optionally and temporarily allow for a 12-month extended grace period at the conclusion of the plan year. Plan years that end in 2020 or 2021 may allow for the 12-month extended grace period.

If implemented by an employer, this generally means employees have 24 months (i.e., 12-month plan year plus 12-month grace period) to incur claims and seek reimbursement from their DC FSA.

The American Rescue Plan Act of 2021 also optionally and temporarily increases the annual limit for DC FSAs from $5,000 to $10,500 (or $5,250 for a married person filing taxes separately), but this change applies only to the 2021 tax year/calendar year, and not the plan year.

Notice 2021-26 explains what all this means for tax purposes by illustrating some examples.

Example 1

An employee is covered by a calendar-year cafeteria plan that offers a DC FSA benefit. The employee chooses no DC FSA benefits for the 2019 plan year. The employee contributes $5,000 for DC FSA benefits for the 2020 plan year but incurs no dependent care expenses during the plan year. The cafeteria plan allows the employee to carry over the unused $5,000 of DC FSA benefits to the 2021 plan year. The employee contributes $10,500 for DC FSA benefits for the 2021 plan year.

The employee incurs $15,500 in dependent care expenses in 2021 and is reimbursed $15,500 by the DC FSA. The $15,500 is excluded from the employee's gross income and wages because $10,500 is excluded as 2021 benefits and the remaining $5,000 is attributable to a carryover permitted under Sec. 214 of the Taxpayer Certainty Disaster Tax Relief Act (TCDTRA), enacted by the Consolidations Appropriations Act of 2021.

Example 2

An employee is covered by a non-calendar year cafeteria plan that offers a DC FSA benefit. The cafeteria plan has a July 1 to June 30 plan year. The employee chooses no DC FSA benefits for the plan year beginning July 1, 2019. For the plan year beginning July 1, 2020, the employee contributes $5,000 for DC FSA benefits, but the employee incurs no dependent care expenses during the plan year. The cafeteria plan allows the employee to carry over the unused $5,000 of DC FSA benefits to the plan year beginning July 1, 2021.

Tax year 2021

The employee contributes $10,500 for DC FSA benefits for the plan year beginning July 1, 2021. The employee has $15,500 available for dependent care expenses for the plan year beginning July 1, 2021. The employee incurs no dependent care expenses during the period from July 1, 2021, to December 31, 2021, and has $15,500 of DC FSA benefits available as of January 1, 2022. For tax year 2021, the employee did not receive any DC FSA benefits because no dependent care expenses eligible for reimbursement under the DC FSA were incurred in the 2021 tax year.

Tax year 2022

For 2022, the exclusion for DC FSA benefits under Code Sec. 129 is $5,000. The employee incurs $7,000 in dependent care expenses during the period from January 1, 2022, through June 30, 2022, and is reimbursed $7,000 by the DC FSA. The cafeteria plan adopts a 2½-month grace period that is added to the end of the plan year beginning July 1, 2021, which allows the employee to use the unused $8,500 of DC FSA benefits until September 15, 2022. The employee contributes $5,000 for DC FSA benefits for the plan year beginning July 1, 2022. The employee incurs $8,500 in dependent care expenses during the period from July 1, 2022, through September 15, 2022, and incurs $2,500 in dependent care expenses during the period from September 15, 2022, through December 31, 2022. The employee is reimbursed $11,000 by the DC FSA ($8,500 plus $2,500). The employee therefore receives $18,000 ($7,000 plus $11,000) in reimbursements of dependent care expenses during the 2022 tax year.

Of the $18,000 received in 2022, $10,000 is excluded from the employee's gross income and wages because $5,000 is excluded under the exclusion for DC FSA benefits under Code Sec. 129 for 2022, and $5,000 of the $7,000 received from January 1, 2022, to June 30, 2022, is excluded because it is attributable to carryovers permitted under Sec. 214 of the TCDTRA that would have been excluded from gross income if used in the preceding tax year (that is, attributable to carryovers to plan years ending before 2023). The remaining $8,000 is included in the employee's gross income and wages because it is not attributable to carryovers permitted under Sec. 214 of the TCDTRA.

Example 3

An employee is covered by a non-calendar year cafeteria plan that offers a DC FSA benefit. The cafeteria plan has a July 1 to June 30 plan year. The employee chooses no DC FSA benefits for the plan year beginning July 1, 2020, and there are no unused amounts from prior plan years available.

Tax year 2021

The employee contributes $10,500 for DC FSA benefits for the plan year beginning July 1, 2021. The employee incurs $5,000 in dependent care expenses during the period from July 1, 2021, to December 31, 2021, and receives $5,000 in reimbursements during tax year 2021. The $5,000 is excluded from the employee's gross income and wages pursuant to Code Sec. 129. The employee has $5,500 of DC FSA benefits available as of January 1, 2022.

Tax year 2022

For 2022, the exclusion for DC FSA benefits under Code Sec. 129 is $5,000. The employee incurs $5,500 in dependent care expenses during the period from January 1, 2022, through June 30, 2022, and is reimbursed $5,500 by the DC FSA. The employee contributes $5,000 for DC FSA benefits for the plan year beginning July 1, 2022. The employee incurs $2,500 in dependent care expenses during the period from July 1, 2022, to December 31, 2022, and is reimbursed $2,500 by the DC FSA. The employee receives a total of $8,000 in reimbursements for DC FSA benefits during tax year 2022. Of the $8,000 received in 2022, $5,000 is excluded from the employee's gross income and wages under the exclusion for DC FSA benefits in Code Sec. 129. The remaining $3,000 received by the employee is included in the employee's gross income and wages.

 

Tag Cloud

Archives

SUBSCRIBE TO THE FLEX BLOG

Stay Connected