The tax uncertainty of recent changes to dependent care flexible spending account plans has been addressed by the IRS.
The Taxpayer Certainty and Disaster Tax Relief Act of 2020 allowed dependent day care FSAs with plan years ending in 2020 or 2021 to include a carryover feature and/or implement an extended grace period for incurring claims. The American Rescue Plan Act of 2021 increased the maximum amount in 2021 that could be excluded from taxable income under a dependent day care FSA to $10,500 for unmarried individuals or individuals filing a joint tax return and to $5,250 for married individuals filing separately.
The one-year exclusion limit increase, when coupled with the carryover and extended claims submission period, created potential tax consequences. Individuals could inadvertently exceed the amount allowed to be excluded from income if they made the full $10,500 contribution and were reimbursed with prior year contributions for claims incurred in 2021. The IRS addressed these potential tax consequences in IRS Notice 2021-26 and IRS Notice 2021-15.
Notice 2021-26 clarifies for taxpayers that if dependent care benefits would have been excluded from income if used during taxable year 2020 (or 2021, if applicable), the benefits will remain excludible from gross income and are not considered wages for 2021 and 2022. This means that dependent day care FSA amounts in 2021 or 2022 attributable to carryovers or an extended period for incurring claims are generally not taxable. A copy of the notice may be accessed by clicking here.
Notice 2021-15 also provides that if an employer adopted a carryover or extended period for incurring claims, the annual limit for a dependent care FSA applies to amounts contributed, not to amounts reimbursed or available for reimbursement in a particular plan or calendar year. A copy of the notice may be accessed by clicking here.
With this new guidance, participants in a dependent care FSA may contribute the maximum amount to their plans for 2021 and 2022 without experiencing unintended tax consequences for reimbursements from prior year funds.
