Beginning in March of 2020, the Internal Revenue Service (IRS) released several pieces of guidance to lessen the impact of COVID-19 on employees who have flexible spending accounts (FSAs) and dependent care assistance program (DCAP) accounts and were unable to use the money they had set aside.
The most recent IRS guidance was issued May 10, 2021 in IRS Notice 2021-26 “Taxation of Dependent Care Benefits Available Pursuant to an Extended Claims Period or Carryover.” As with prior IRS guidance on this topic, employers may, but are not required to, amend their plans to include the flexibility that the IRS is allowing. As a result of Notice 2021-26, participants may carry over unused DCAP amounts to a following year (2020 to 2021 and 2021 to 2022), extend the claims period for 2020 or 2021 for 12 months, and increase the total amount of contributions in 2021 to $10,500.
Taxation
Notice 2021-26 clarifies that DCAP amounts carried over from 2020 to 2021 or from 2021 to 2022 are not considered wages and are therefore excluded from income when used in the following year if they would have been excluded from income if they had been used during the original taxable year ending in 2020 or 2021.
However, plan sponsors should be aware of how the taxation could apply to employees based on whether the plan is a calendar year plan or a non–calendar year plan.
Calendar Year Plans
The changes that plans may incorporate appear easiest to implement for plans operating on a calendar year basis. For example:
- Plan year begins January 1, 2020.
- Employee contributed $5,000 for 2020 but incurred no dependent care expenses during the plan year.
- The plan was amended to allow the employee to carry over the unused $5,000 to the 2021 plan year.
- For the 2021 plan year, the employee elected a contribution of $10,500.
- The employee has $15,500 in dependent care expenses in 2021 and is reimbursed for that total by the plan.
- The $15,500 is excluded from the employee’s gross income, including $5,000 from the 2020 carryover and $10,500 from the 2021 contribution.
Non–Calendar Year Plans
For non–calendar year plans, using a plan year beginning July 1 and ending June 30 for the 2021-2022 plan year, the increased exclusion amount will not apply to reimbursements incurred during the 2022 portion of the plan year. This means that reimbursements of more than $5,000 from 2021 DCAP contributions to pay for DCAP expenses incurred in 2022 may be taxable under Section 129.
To avoid this situation, non–calendar year plans could consider limiting DCAP contributions to $5,000 for plan years ending in 2022.
Below is an illustration of how changes could affect taxation of these dependent care benefits:
For the 2020 –21 plan year:
- Employee contributed $5,000 for 2020 but incurred no dependent care expenses during that time.
- The plan was amended to allow the employee to carry over the unused $5,000 to the 2021-22 plan year.
For the 2021-22 plan year:
- The employee elects a new contribution of $10,500 beginning July 1. The $5,000 carryover and now the $10,500 combine for $15,500.
- From July 1, 2021 to December 31, 2021, the employee incurs $5,000 in expenses and receives $5,000 in reimbursements.
- The $5,000 is excluded from the employee’s gross income.
- From January 1, 2022 through June 30, 2022, the employee incurs $5,500 in expenses and is reimbursed $5,500.
- On July 1, 2022, the employee elects a new contribution of $5,000.
- From July 1, 2022 to December 31, 2022, the employee incurs $2,500 of expenses and receives $2,500 in reimbursements.
- During 2022, the employee would receive $8,000 in reimbursements. $5,000 is excluded from the employee’s gross income, and $3,000 will be considered taxable.
Next Steps for Employers
As mentioned above, employers are not required to adopt any of the IRS allowances in their plans. However, plans should be amended if these or other changes are made. The plan can be amended retroactively if:
- The amendment(s) are adopted prior to the end of the calendar year beginning after the end of the plan year in which the amendment is effective (for example, calendar year 2020 plan amendments must be adopted on or before December 31, 2021).
- The employer notifies eligible employees of the changes to the plan.
[Related Reading: How the American Rescue Plan Act of 2021 Impacts Dependent Care Assistance Programs]
Developed by International Foundation Information Center staff. This does not constitute legal advice. Please consult your plan professionals for legal advice.
Anne Newhouse, CEBS
Information/Research Specialist at the International Foundation of Employee Benefit Plans
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