UPDATE: The IRS released Notice 2021-26 addressing the taxation issues covered in this article. The IRS Notice clarifies that dependent care benefits that would have been excluded from income if used during the preceding year (i.e., during taxable years ending in 2020 or 2021), will remain excludable from income (tax free) for taxable years ending in 2021 and 2022. For more on Notice 2021-26, see our blog article.
Under the recently enacted Consolidated Appropriations Act of 2021 (CAA) and American Rescue Plan Act (ARPA), Congress provided temporary relief to the “normal” rules surrounding employer-provided dependent care assistance programs. This relief allows employers to extend the time employees have to use forfeitable dependent care funds and increases the amount employees can receive in pre-tax employer-provided dependent care assistance to $10,500 (from $5,000) for the 2021 calendar year.
The new relief provides employers the option to allow the following changes related to their dependent care flexible spending arrangements (DC FSAs):
- For the 2020 and 2021 plan years, implement a grace period of up to 12 months or a carryover of up to all unused amounts; and
- For calendar year 2021, increase the amount employees can elect in pre-tax salary deductions up to $10,500.
Though these changes are designed to help employees, employers should be aware of potential issues that may arise if they choose to implement the new relief. Most notably, these changes may cause a DC FSA to fail non-discrimination testing and may cause adverse tax consequences for employees.
IRS Code Section 129 allows employees to exclude up to $5,000 ($2,500 for married individuals filing separately) from their gross income for employer-provided dependent care assistance. Most employers provide dependent care assistance through a dependent care flexible spending arrangement (DC FSA), which allows employees to elect salary deductions to pay for eligible dependent care expenses on a pre-tax basis.
Grace Periods and Maximum Exclusion Limits: Under DC FSA rules, employees must use their entire DC FSA election within the plan year or forfeit remaining amounts. DC FSAs can also provide a grace period of up to 2 ½ months after the end of the plan year whereby employees can use any remaining funds. While a grace period avoids forfeiture of unused funds, the taxability of those funds is a separate issue.
Amounts available during a grace period may become taxable if it causes an employee to exceed their maximum exclusion limit for the subsequent calendar year. This is because the maximum exclusion limit depends on whether dependent care expenses are provided within a calendar year (and does not take into account whether an employee uses funds from a prior year to reimburse those expenses). Therefore, an employee will exceed their maximum exclusion limit if they use funds from a prior year in addition to that year’s maximum allowed amount. Amounts that exceed the maximum exclusion limit must be included as gross income (i.e., are taxable).
- Example: In 2018, an employee elects $5,000 toward their DC FSA and reimburses $4,000 by the end of the plan year. The DC FSA has a 2 ½ month grace period whereby the employee can incur and use the remaining $1,000. In 2019, the employee again elects $5,000 toward their DC FSA and incurs $6,000 in expenses ($1,000 during the grace period and $5,000 from that year’s maximum). For 2019, the employee exceeds the $5,000 maximum exclusion limit and the $1,000 used during the grace period cannot be excluded from the employee’s gross income (i.e., the $1,000 becomes taxable income).
Optional COVID Relief
Due to the nature of the COVID-19 health emergency and the unavailability of dependent care, Congress recognized that employees may have unused DC FSA amounts in 2020. As such, Congress permitted employers to allow employees additional time to use DC FSA amounts by implementing a grace period (up to 12 months) or a carryover (up to all unused amounts) for the 2020 and 2021 plan years. Previously, grace periods could only be up to 2 ½ months and carryovers were not allowed for DC FSAs.
As discussed above, funds from a prior calendar year (available through a grace period or carryover) may be taxable if it causes employees to exceed their maximum exclusion limit for a subsequent calendar year. Congress appeared to address the taxation issue by increasing the maximum exclusion to $10,500 for the 2021 calendar year. Under the increased exclusion, employees could carryover up to $5,000 remaining from the 2020 calendar year, elect the full $5,000 for the 2021 calendar year, and incur all $10,000 in the 2021 year on a pre-tax basis (because they would not be exceeding the new $10,500 limit).
In addition, the maximum exclusion increase would allow employers to increase the amount employees could elect in salary deductions for the 2021 calendar year. It is important to note that the maximum exclusion limit applies on a calendar year basis and not on a plan year basis.
Potential Issues When Adopting COVID Relief
Though employers have the option to adopt the relief, employers should be aware of the following potential issues that may arise (the following may be subject to change based on further IRS guidance):
Potential Taxation Issues for the 2021 Calendar Year
If an employer increases the salary deduction limit for 2021 to $10,500 and an employee elects the full $10,500, the employee may be subject to taxes if they use the entire $10,500 in addition to remaining amounts available from 2020 through a grace period or carryover. This is because all expenses incurred during the 2021 calendar year count against the $10,500 maximum exclusion limit.
Employer Tip: Employers may decide not to increase the maximum salary deductions for 2021 to limit potential taxation issues for employees. If employers do decide to increase allowable salary deductions, employers may want to notify employees of these potential taxation issues so employees are educated when making their annual elections. To avoid taxation, employees should plan to limit their 2021 elections so that, when combined with available amounts from a grace period or carryover, they do not exceed $10,500 (or they should plan to only use $10,500 during calendar year 2021 to avoid taxation).
- Example: In 2020, John elects $5,000 toward his DC FSA and incurs $2,000 in expenses. The remaining $3,000 is carried over into 2021. In 2021, John elects $10,500 toward his DC FSA and incurs $13,500 in dependent care expenses. For 2021, John exceeds the $10,500 maximum exclusion and may need to include $3,000 as taxable income. To avoid this taxation, John could have instead elected $7,500 for 2021 (which, combined with his 2020 rollover, would be $10,500) or John could have only incurred and reimbursed $10,500 in 2021 (so that the additional $3,000 could be carried over into 2022).
Non-discrimination Testing (NDT)
If an employer decides to increase the salary deduction to $10,500, highly compensated employees (HCEs) may elect more than non-HCEs, causing the DC FSA to fail NDT (which compares, among other things, HCE elections to non-HCE elections). If a plan fails NDT, HCEs lose tax preferential status for their DC FSA elections (i.e., HCEs must include their DC FSA elections in their gross income).
Employer Tip: Employers whose DC FSA has failed NDT in the past should be aware of heightened NDT concerns when adopting a higher maximum election. If employers are concerned about failing NDT, they may want to limit the maximum election limit for their HCEs or only permit non-HCEs to elect the higher maximum. Further, employers can conduct a mid-year NDT after new elections are made to determine whether the higher salary deduction limit is likely to cause a NDT failure. Testing early will allow an employer to make corrective changes before year-end.
Potential Taxation Issues for the 2022 Calendar Year
The 2022 maximum exclusion limit remains $5,000 (absent further IRS relief). As such, if an employer adopts a grace period or carryover for the 2021 plan year, employees may need to pay taxes on amounts rolled over into the 2022 calendar year if they exceed the $5,000 maximum exclusion limit. This taxation issue is compounded if employees can elect $10,500 in 2021 and rollover potentially large amounts into 2022.
Employer Tip: Employers may want to notify employees of potential taxation issues during 2022 open enrollment so they can adjust their elections based on how much they have in carryover/grace period amounts from 2021. Employees who elect up to the $10,500 limit should plan to use a significant portion of that amount during the 2021 calendar year to avoid having to rollover large amounts into the 2022 calendar year (which has a lower exclusion limit).
- Example: In 2021, Sean elects $10,500 toward his DC FSA and incurs $5,500 in dependent care expenses. The remaining $5,000 is carried over into the 2022 calendar year. If Sean elects $5,000 in 2022 and incurs $10,000 in expenses, Sean may have to include $5,000 as gross income. To avoid taxation of the carryover, Sean could have elected $0 in 2022 and used the remaining $5,000 tax free on expenses incurred in 2022. It is important to note that Sean would be unable to carryover funds remaining at the end of 2022 into 2023 since carryover provisions are only temporarily allowed for plan years ending in 2020 and 2021 (though Sean may have up to 2 ½ months in 2023 to use remaining amounts if his employer has adopted a grace period).
Employers must report the total amount of pre-tax contributions employees elect toward their DC FSA for the calendar year in Box 10 of Form W-2 (regardless of whether the employee forfeits the amounts at the end of the plan year). The IRS confirmed that employers are not required to report amounts available in a carryover or grace period on employees’ W-2s. Further, these amounts are not subject to federal income tax as long as employers reasonably believe the employee can exclude these amounts from their income under Section 129. It is unclear how employers will be impacted if they knowingly take salary deductions that may cause the employee to exceed their annual maximum exclusion limit (because of a large carryover or grace period), though arguably employers would be unaware of employees’ intention to actually apply those amounts to any given calendar year. In addition, if an employer fails NDT mid-year, they have become aware that they may not be able to exclude the entire DC FSA limit from their HCEs’ income.
If an employee exceeds their maximum exclusion limit for the calendar year, they are required to report it as taxable income on IRS Form 2441. The IRS announced plans to update IRS Form 2441 instructions to address issues that may arise for employees taking advantage of the COVID relief.
Employers should consider potential issues when deciding whether to adopt carryover/grace period provisions or whether to increase the maximum DC FSA election to $10,500 in 2021. If employers decide to adopt these provisions, they should work with their FSA vendor to implement the changes, amend plan documents, and notify employees. In addition, employers may also want to work with their DC FSA vendor to inform employees of potential taxation issues so they can make informed elections.
- Sequoia Foreword: Consolidated Appropriations Act of 2021
- Sequoia Foreword: American Rescue Plan Act (ARPA)
Disclaimer: This content is intended for informational purposes only and should not be construed as legal, medical or tax advice. It provides general information and is not intended to encompass all compliance and legal obligations that may be applicable. This information and any questions as to your specific circumstances should be reviewed with your respective legal counsel and/or tax advisor as we do not provide legal or tax advice. Please note that this information may be subject to change based on legislative changes. © 2021 Sequoia Benefits & Insurance Services, LLC. All Rights Reserved