IRS NOTICE 2021-26: Taxation Guidance for DCFSA Plans that Adopted 2021 COVID Relief Provisions

CAA: Carryover/Grace Period Provisions are Non-Taxable

On May 10, 2021, the IRS released Notice 2021-26 on the taxation of dependent care benefits available pursuant to an Extended Grace Period or Carryover provision under a Section 125 Plan.

The IRS explained in this Notice that Dependent Care FSA (DCFSA) balances carried forward under temporary COVID-19 relief provisions retain their non-taxable status from participating employees’ gross income and wages.

The Consolidated Appropriations Act of 2021 (CAA) allows an extended carryover of unused benefits from 2020 plan years to 2021 and from 2021 to 2022. Alternatively, plans may allow a 12-month extension of their claims period (Grace Period) for plan years ending in 2020 or 2021 under the CAA. Notice 2021-26 clarifies that the carryover dollar amount does not impact the annual limit set by the Internal Revenue Code under Dependent Care FSA plans for the taxable years ending in 2021 and 2022.

ARPA: Cap Increase Provision May be Taxable

The carryover and/or grace period provisions allowed under the CAA (mentioned above) will not interfere with electing the maximum $10,500 benefit under the American Rescue Plan Act of 2021 (ARPA) for a plan year beginning in 2021 but ending in 2022. Therefore, there is not applicable taxation for these plans. Notice 2021-26 provides examples of this on pages 3-4 (Examples 1 and 2).

When electing $10,500 in DCFSA benefits for a non-calendar plan year beginning in 2020, 2021 and 2022, taxation applies. Notice 2021-26 provides examples of the possible tax consequences on pages 4-5 (Examples 3 and 4).

  • Employers with non-calendar plan years need to be sure they considered the possible adverse impact for an employee’s taxable income and tax returns and ensure that they reduce these maximum elections beginning January 1, 2022 to the amount allowed under IRS Code Section 129.

What DCFSA Plan Sponsors Need to Know and Do:

  • Review the taxable vs non-taxable annual limits for DCFSA in the Notice.
  • Know that the cap increase to $10,500 for 2021 reverts back to the original $5,000 maximum for 2022 – this is especially true for non-calendar year plan years that must change election amounts as of January 1 ,2022.
    • The BASIC system will be updated to reflect this change.
  • Do not permit employees to make contributions to a DCFSA in excess of the applicable limits.
  • Review and understand any potential taxable income to employees and communicate it to them appropriately.