FAQ: If a participant is reimbursed more than $5,000 in a calendar year for dependent care FSA (DCAP) expenses due to an extended grace period or carryover provision, is the amount above $5,000 subject to taxation?
In short, no. The American Rescue Plan Act of 2021 (ARPA), passed by Congress on March 10, 2021, temporarily increases the allowable exclusion for DCAPs.
Generally, a participant’s DCAP reimbursement amount in a calendar year is limited to $5,000 if the employee is married and filing a joint return or if the employee is a single parent (or $2,500 if the employee is married filing separately). Further, any account balances available at the end of the plan year are forfeited (unless the DCAP permits a grace period).
The Consolidated Appropriations Act of 2021 (CAA), passed by Congress in December 2020, provides employers with relief options related to administering health FSAs and DCAPs. One such option provided by the CAA is that employers are permitted, if they choose, to allow up to the full year-end DCAP account balance to carry over into the subsequent plan year (a feature otherwise limited to health FSAs and capped at $550 as indexed). The CAA also permits an extended grace period up to 12-months (otherwise limited to 2.5 months) after the end of the plan year. Both the carryover and extended grace period provisions are applicable to plan years ending in 2020 and 2021.
Then the IRS released Notice 2021-15 in February 2021, clarifying much of the guidance provided in the CAA and confirming that unused DCAP amounts carried over from prior years or made available during an extended period for incurring claims are not considered when determining the annual limit applicable for the following year. This means that a participant who takes advantage of an extended carryover or grace period can still contribute up to the annual limit in the subsequent plan year. However, neither the CAA nor Notice 2021-15 amend the annual DCAP limit permitted to be excluded from income.
The ARPA addresses this issue by providing a temporary increase for this exclusion to $10,500 (or $5,250 if the employee is married filing separately) for taxable years beginning after December 31. 2020, and before January 1, 2022. This new increase in the DCAP limit should provide relief for employees whose employers choose to permit the temporary extended carryover and grace period DCAP provisions provided by the CAA. Accordingly, the amounts in excess of $5,000 that are reimbursed through a DCAP during a taxable year will not be treated as taxable income for participants (for the taxable year beginning after December 31, 2020, and before January 1, 2022).