Since the onset of the COVID-19 pandemic, many of your employees may have seen funds in their flexible spending arrangements (FSA)—whether for health or dependent care—go unspent. Fortunately, two recent legislative packages provide changes to FSA rules. The laws also give employers a lot of discretion—and therefore, a lot to consider. Here’s what you need to know.
FSA basics
FSAs come in two flavors, health and dependent care. Health FSAs are employer-sponsored accounts where employees can contribute pre-tax funds to use for qualified medical expenses for themselves, their spouses, and their dependents. For 2021, employees can exclude up to $2,750 in contributions to health FSAs from their taxable income.
Dependent care FSAs (DCFSAs), also known as dependent care assistance programs (DCAPs), cover qualified dependent care expenses. Employees can use the funds for work-related costs for care—basically, care that makes it possible for them to be present, or look, for work. The care can be for:
- Dependents under 13 years of age at the time of the care
- Dependents who are physically or mentally incapable of self-care and live with the employee for more than half of the year
- A spouse who is physically or mentally incapable of self-care and lives with the employee for more than half of the year
Unlike health FSAs, the annual limit for tax-free DCFSA contributions is set by statute and not indexed for inflation annually. The limit is $5,000 per year for single tax filers or married couples who file joint tax returns and $2,500 for married couples filing separately, subject to restrictions based on earned income.
Because both health FSAs and DCFSAs are funded through pre-tax payroll deductions, your employees benefit by:
- Reducing their taxable income through contributions
- Saving about 30 percent on qualified expenses (about the amount they would have paid in taxes on the money)
However, the FSAs differ when it comes to the “use-it-or-lose-it” rules for unused funds at the end of the plan year.
Employees can carry over up to $550 in unused health FSA funds to the next plan year and still contribute up to the maximum for that subsequent plan year. Employers also can offer employees a grace period of up to 2.5 months after the plan year to spend the funds. You can elect to offer either the carryover or the grace period (or neither) but not both.
DCFSA funds can’t be carried over to the next plan year. Employers can, however, provide a grace period of up to 2.5 months to spend funds that are unused at year-end.
The CAA loosens the use-it-or-lose-it rules
The Consolidated Appropriations Act (CAA), signed in late 2020, addresses the problem of unused FSA funds due to the pandemic head-on.
For starters, it temporarily allows employees to carry over all or some of their unused health FSA or DCFSA funds from a plan year ending in 2020 or 2021 to the next plan year. (Plan years typically run on a calendar basis, from January through December, but some plans may run on a mid-year cycle, such as May through April of the following year.)
You can permit this for only 2021 or 2022, both, or neither. Alternatively, you could extend the grace period for spending unused funds up to 12 months for plan years ending in 2020 or 2021. You can increase the permissible carryover amount or extend the grace period even if you don’t currently have a carryover or grace period provision in your plan.
You also can amend your cafeteria plan to allow employees to make mid-year elections for both kinds of FSAs without the typically required qualifying life event (for example, marriage, divorce, birth, or adoption) for plan years ending in 2021.
That means an employee who isn’t already enrolled can elect to enroll in a health FSA or DCFSA to benefit from the expanded carryover or extended grace period. And those who are currently enrolled can increase their contribution amounts.
Mid-year changes must be prospective, but employees can apply amounts contributed after making the change to cover qualified expenses they incurred earlier in the plan year.
Employers have some wiggle room. For example, you can set a specific timespan during which employees must make elections or limit the types of elections they can make mid-year.
The CAA also changes the rules regarding post-termination access to health FSA funds. It provides that employers can allow employees who leave the company in 2020 and 2021 to access unused funds for the remainder of the plan year in which they leave—including any extended grace periods. Normally, they would forfeit such funds unless they stayed on the employer’s health care plan under COBRA.
Also, IRS guidance on the CAA clarifies that employers can increase the maximum age of a dependent who incurred eligible DCFSA expenses to 13 years for certain plan participants. This exception to the usual exclusion of dependents age 13 or older applies only for unspent funds at the end of the 2020 plan year.
So employees with children who turned 13 during the 2020 plan year, can be allowed to carry over unused funds to cover qualified expenses in the 2021 plan year—until a child turns age 14. The funds also can be applied to dependents who turn age 13 during the 2021 plan year.
The ARPA boosts DCFSA contribution limits
The American Rescue Plan Act (ARPA), the so-called COVID stimulus package enacted in March 2021, also includes provisions that can positively affect DCFSAs.
It more than doubles the maximum allowable contributions for DCFSAs for plan years beginning in 2021:
- For single filers and married filing jointly, from $5,000 to $10,500
- For married filing separately, from $2,500 to $5,250
As a result, carryover amounts allowed by the CAA won’t be treated as taxable income for the employee. Without the higher limit for 2021, unused DCFSA amounts from 2020 used in 2021 could have ended up taxable for employees who also make 2021 contributions and use those amounts for 2021 expenses.
For example, if a single filer contributes $5,000 annually, carries over $4,000 from 2020, and spends those funds and their 2021 contribution of $5,000 in 2021, they would exceed the usual limit of $5,000. The employee would owe taxes on the $4,000 surplus.
Employers that want to increase the limits on their DCFSA plans will need to determine if amendments are necessary. One example might be, if a plan states the specific numerical limits ($2,500 and $5,000) or merely uses language that incorporates the statutory maximum without stating the amounts. You’ll need to amend if your plan gives specific limits.
If amendments are necessary, the ARPA provides that, as long as you amend the plan retroactively by the last day of the plan year covered by the amendment, you won’t violate rules.
Your next steps
Employers have several factors to mull as they decide how to proceed under the recent changes. For example:
- Suppose you don’t currently have a carryover or grace period provision for a health FSA or a grace period provision for a DCFSA. Should you add one or the other?
- Are your employees’ FSA balances actually larger than usual? If not, it might not be worth the administrative hassle to expand the carryover limit or grace period.
- Are your employees’ DCFSA balances significantly more than their health FSA balances, or vice versa? If so, you might want to make adjustments for one type of FSA but not the other.
- If you opt to expand the carryover limit or grace period, should you permit the maximum for each?
- Do you rely on funds forfeited by terminated employees to help offset plan costs? If you allow those employees to access funds for the remainder of the plan year, you may have a smaller offset.
Remember, too, that nondiscrimination testing still applies to DCFSAs. If your DCFSA plan has struggled to satisfy the 55 percent a,verage benefits test, you might find it difficult to increase the contribution limits.
It’s also worth considering how the ARPA’s substantial temporary increase in the child and dependent care tax credit might come into play. For 2021, employees can claim a refundable 50 percent credit on up to $8,000 in care expenses for one child or dependent and up to $16,000 in expenses for two or more children or dependents. The credit begins phasing out when household income levels exceed $125,000.
Expenses covered by a DCFSA don’t qualify for the credit, though. Some employees might fare better from a tax perspective by maximizing the child and dependent care tax credit for 2021, rather than maximizing their DCFSA contribution.
Finally, if you decide to allow mid-year changes to contribution amounts, let your employees know ASAP so they can spread their FSA salary reductions across as many pay periods as possible..
