8903 / What is a dependent care flexible spending arrangement (FSA)?
A dependent care flexible spending arrangement (FSA) is a program that is established under IRC Section 125 to provide for the reimbursement of certain expenses related to dependent care that have already been incurred. This benefit may be provided as a stand-alone plan or as part of a traditional cafeteria plan.
Substantially the same rules apply to dependent care FSAs as health FSAs (see Q 8902), except that the maximum amount of reimbursement need not be available throughout the entire period of coverage. A plan may limit a participant's reimbursement to amounts that were actually contributed to the plan and that are still available in the participant's account.1 Contributions to a dependent care FSA may not exceed $7,500 (or $3,750 for a married taxpayers filing separately.2
Like a health FSA, a dependent care FSA may permit a grace period of no more than 2½ months following the end of the plan year for participants to incur and submit expenses for reimbursement.3 A dependent care FSA may not, however, permit the same $500 carryforward option that is now permitted in the context of health FSAs.
The IRS has also approved the use of employer-issued debit and credit cards to reimburse for recurring dependent care expenses. Because expenses may not be reimbursed until the dependent care services are provided, reimbursements through debit cards must flow in arrears of expenses incurred.4
Planning Point: Employers should consider the nondiscrimination testing rules that apply to dependent care FSAs when amending their plans to take advantage of the higher post-OBBB maximum contribution amounts.To pass nondiscrimination testing, non-highly compensatedemployees must receive at least 55% of the benefit amounts provided to highly compensated employees.Because highly compensated employees are more likely to increase their contributions to take advantage of the new maximum, the risk of failing the nondiscrimination test increases.Employers should also consider the enhanced child and dependent care tax credit--going forward, this enhanced credit may be more valuable for lower-income taxpayers, meaning that they may elect to forgo dependent care FSA contributions and increase the risk that the plan may fail nondiscrimination testing.
Covid-Era Changes
The dependent care FSA rules were relaxed in response to the COVID-19 pandemic. Typically, a dependent care flexible spending account (FSA) can be used to cover childcare for children under age 13. Under the year-end Consolidated Appropriations Act (CAA) of 2021, employers could amend dependent care FSAs to allow participants who have a qualifying child turning age 13 to continue to receive reimbursements for the child's dependent care expenses for the remainder of the plan year and, with respect to any remaining balance, the next plan year up until the child turns 14. This is true if the child turned age 13 during a plan year with a regular enrollment period on or before January 31, 2020 (i.e., the 2020 year for calendar-year plans).
Planning Point: The ARPA doubled the annual limit under IRC Section 129 from $5,000 peryear to $10,500 in 2021 ($5,250 for taxpayers who are married and file separate returns). Employers could amend their plans retroactively through the end of 2021 to provide for the increased limit.
Further, the CAA temporarily allowed dependent care FSAs to be amended to allow participants to carry over unused amounts in the participant's account from 2020 to 2021, and from 2021 to 2022, without limit. Dependent care FSAs could allow prospective election changes for the plan year ending in 2021, regardless of whether a permitted election change event occurred.
Planning Point: IRS Notice 2021-26 clarified that participants could take advantage of both (1) tax-free reimbursements of contributions made during the 2021 plan year up to the maximum $10,500 limit and (2) tax-free reimbursements of amounts carried over from the prior year. In other words, a participant with a $5,000 carryover amount from 2020 and a $10,500 contribution in 2021 could take tax-free distributions up to $15,500 in 2021 if that participant incurred enough qualifying expenses during the 2021 plan year.
1. Prop. Treas. Reg. § 1.125-5.
2. IRC § 129(a)(2)(A); Notice 2012-40, 2012-1 CB 1046.
3. Notice 2005-42, 2005-1 CB 1204; Notice 2012-40, 2012-1 CB 1046.
4. Notice 2006-69, 2006-2 CB 107.