Act Now to Benefit from Temporary Increases to the Dependent Care FSA
The American Rescue Plan Act of 2021 (ARPA) provides a temporary increase in dependent care flexible spending accounts (FSAs). Businesses and their employees should act swiftly to take advantage of this temporary relief.
The dependent care FSA is a pre-tax benefit. An employee can choose to deduct pre-tax funds from their paychecks to cover qualified dependent care expenses, such as preschool, summer day camp, before or after school programs, and child or adult daycare. These pre-tax deductions reduce a taxpayer’s gross income for income tax purposes, resulting in lower taxable amounts.
For calendar year 2021 only, the total amount that can be excluded from taxable income is $5,250 for single filers, or $10,500 for married couples filing a joint return (the previous limits were $2,500 per individual or $5,000 for married couples filing jointly.)
Employers – amend dependent care FSA plan documents to allow your employees to make changes
To claim this temporary increase in benefits in 2021, employers must amend their dependent care FSA plan documents by the last day of the plan year (as determined by their plan administrator.) Changes to plan documents will then allow employees to make mid-year modifications to their current plan elections and payroll deductions. The new temporary provision is effective for plan years beginning after December 31, 2020, and before January 1, 2022, which can be claimed retroactively.
Prior to COVID-19, dependent care FSA rules allowed for a maximum two-and-a-half-month grace period to spend any unused dependent care FSA funds from the prior year (allowing participants to use the funds through mid-March.) Since the Consolidated Appropriations Act of 2021 (CAA) was signed into law on December 27, 2020, amended plans now provide for a grace period of up to twelve months, allowing taxpayers to use their 2020 plan funds through the end of 2021.
Employers have two options under the current CAA provisions: they can either allow a 12-month grace period for unused funds from each of those years or provide a carryover feature that permits employees to carry over their unused funds to be used in the subsequent year. Whichever they choose should be clearly indicated in the plan documents provided to employees.
IRS guidance has confirmed that employer reporting will not change, and they may continue reporting their obligation by reporting the total amount of employee pre-tax contributions, even if unused amounts from 2020 will be available for use during the grace period in 2021.
Employees: budget your spending when making mid-year modifications to your contributions
To qualify for this benefit, taxpayers must have earned income. If married and filing jointly, both spouses must be working or a spouse may qualify if they are actively seeking employment. In addition, the dependent care expenses must be incurred before the child turns 14, or by the end of the 2021 plan year, whichever is earlier.
Taxpayers should budget their spending and factor in any unused portions when determining the amount they wish to withhold in their dependent care FSA for the 2021 tax year. Unlike the healthcare FSA, the $10,500 is a reimbursement limit, not a contribution limit. If an employee has unused funds from 2020, they should not maximize the contribution limit, so they do not go over the $10,500 reimbursement limit.
For example, John Smith elected to contribute $5,000 to a dependent care FSA in 2020, but as a result of the COVID-19-related restrictions and shutdowns, he did not incur any eligible dependent care expenses that year. As permitted under the CAA, John Smith’s employer amended its dependent care FSA plan documents to provide a 12-month grace period. As a result, the unused $5,000 is available for reimbursement of eligible expenses incurred in 2021.
If John Smith elects to contribute another $5,000 to the dependent care FSA for 2021 during this year’s open enrollment period, he will have $10,000 toward eligible dependent care expenses in 2021. Because ARPA increased the exclusion limit to $10,500, John Smith can exclude the entire $10,000 from his taxable income for expenses incurred in 2021.
Employees who do not use the entire amount available for 2021 will have until December 31, 2022 to use any remaining funds from the 2021 plan year. If they surpass the contribution limit and end up with additional funds after reimbursement, they may have additional taxable income in 2022.
If you have any questions about your Dependent Care Flexible Spending Account plan or how to carefully plan to maximize potential tax benefits, contact me or another member of Kaufman Rossin’s tax advisory services department.