On Monday, 05/10/2021, the IRS released a notice that impacts recent Dependent Care flexible spending account (FSA) relief. It’s important to review recent legislation when considering this announcement.

The Consolidated Appropriations Act, 2021 (CAA) allowed for plan sponsors to amend their Dependent Care FSAs to include either unlimited rollover of unused benefits or an extended grace period, up to 12 months for plan years that end in 2021 or 2022. As part of COVID-19 relief, both of these provisions allow participants to use unspent dollars from one plan year during the next plan year.

Further, the American Rescue Plan Act allowed for plan sponsors to temporarily amend their Dependent Care FSA to increase their plan limit from $5,000 to $10,500 and increased the tax-free nature of the benefit for the calendar year of 2021.

Notice 2021-26

On Monday, 05/10/2021, the IRS released Notice 2021-26 clarifying the taxation of the Dependent Care FSA benefits for plans that adopted relief under the CAA to provide additional time through either rollover or grace period to incur claims.

Based on this notice, Dependent Care FSA participants are not subject to income tax on reimbursements in excess of the calendar year statutory* maximum if the excess was from a prior plan year’s unused funds, made available through the CAA relief of rollover or the extended grace period.

Typically, if a participant is reimbursed more than the statutory* limit due to the standard 2 month and 15 day grace period, the excess amount over the statutory limit must be included as taxable income. While this notice does not address plans that already had the standard grace period, participants of employers that amended their plans due to the CAA relief benefit from the tax relief.

Below is an example of how this might work for a calendar year plan as a result of the notice:

• The Dependent Care FSA participant’s employer adopted the extended grace period for their 2020 calendar year plan.
• The participant had $2,500 in unused funds as of 12/31/2020.
• In 2021, the employer amended their plan to allow for elections up to $10,500.
• The participant elected $10,000 in the 2021 plan year.
• The participant submitted $12,500 of claims incurred during 2021.
• Because of the relief, the participant would not include any of the $12,500 reimbursement that occurred in 2021 in their taxable income amount for the tax year 2021. Without this relief, $2,000 would have been included as taxable income, based on the statutory maximum of $10,500 for 2021.

The relief in this notice does not apply to participants who are reimbursed for expenses in excess of the statutory maximum for reasons other than the extended grace period and rollover relief provided through CAA. This includes participants who are reimbursed for claims incurred in 2022 in excess of the statutory limit due to an off-calendar year plan, even if the plan allowed for greater elections due to the increased plan limits provided under the American Rescue Plan Act.

Below is an example of this non-calendar year scenario:

• A plan running from 7/1/2021 – 6/30/2022 allows for elections up to $10,500.
• A Dependent Care FSA participant elects $10,000 as of 7/1/2021.
• The participant lowers their election to $7,500 as of 1/1/2022.
• The participant does not participate in the plan beginning 7/1/2022.
• The participant submits $7,500 in expenses, all incurred in 2022.
• The relief does not apply in this scenario as the excess amounts were not due to an extended grace period or rollover permitted by CAA. Because the relief does not apply, the participant has to include $2,500 as taxable income, as this amount exceeds the $5,000 statutory limit.

For additional examples and more information, please review IRS Notice 2021-26.

*The 2021 statutory limits are:

• Single: Your tax-free reimbursable limit is the lesser of $10,500 or your net taxable pay (income after pre-tax payroll deductions are taken) for the year the expenses are incurred
• Married and your spouse works: Your tax-free reimbursable limit is the lesser of $10,500 ($5,250 if filing income taxes separately), your net taxable pay (your income after pre-tax payroll deductions are taken), or your spouse's net taxable pay for the year the expenses are incurred
• Married and your spouse is a full-time student or is physically or mentally incapable of caring for themselves
  • Your tax-free reimbursable limit is $250 in any one month if you have only one dependent
  • Your tax-free reimbursable limit is $500 in any one month if you have more than one dependent

The 2022 statutory limits are:

• Single: Your tax-free reimbursable limit is the lesser of $5,000 or your net taxable pay (income after pre-tax payroll deductions are taken) for the year the expenses are incurred
• Married and your spouse works: Your tax-free reimbursable limit is the lesser of $5,000 ($2,500 if filing income taxes separately), your net taxable pay (income after pre-tax payroll deductions are taken), or your spouse's net taxable pay for the year the expenses are incurred
• If you are married and your spouse is a full-time student or is physically or mentally incapable of caring for themselves
  • Your tax-free reimbursable limit is $250 in any one month if you have only one dependent
  • Your tax-free reimbursable limit is $500 in any one month if you have more than one dependent
• These limits could change if the temporary relief is extended or made permanent by congressional action.