IRS Relaxes Taxation of Daycare FSA Enhancements

The American Rescue Plan Act increased the calendar year 2021 income exclusion limit for daycare FSA reimbursements from the usual $5,000 to $10,500 (half for married filing separately). However, there was a chance someone could have up to $5,000 in unspent daycare FSA funds from 2020 which, under relief provided by the Consolidated Appropriations Act (CAA), might be available in 2021 and 2022 via enhanced grace periods or carryovers.  Those funds coupled with new contributions of $10,500 could give them access to more than $10,500 this year and next year.  As a result, any excess reimbursements over $10,500 for calendar year 2021 (half for married filing separately) would be taxable when filing your personal taxes in April 2022, and any excess reimbursements over $5,000 for calendar year 2022 (half for married filing separately) would be taxable when filing your personal taxes in April 2023.

To that end, we’ve been advising employers to consider limiting new contributions this year to $10,500 less any funds brought forward from 2020 to avoid any surprise taxation when people file tax returns in April 2022 (and to be careful about enhancements offered for 2021 unspent funds to be available in 2022).  We’ve been advising employers with non-calendar year plans to consider whether to allow anyone to contribute more than the usual $5,000 (half for married filing separately), since the employer can’t reasonably determine in advance how much will be reimbursed during the calendar year and will want to ensure calendar year reimbursements don’t exceed $10,500 in 2021.  Employers also needed to be mindful that the $10,500 limit is only for 2021, so if someone has well over $5,000 available this year and is unable to spend it this year after all, and those unused funds are available in 2022 in addition to new contributions in 2022, then the employee may receive way more than $5,000 in daycare FSA reimbursements in 2022 (half for married filing separately) and be in for a huge tax surprise when filing their personal taxes in April 2023.

However, the Treasury Department and IRS recognized this issue and believe it was Congress’s intent to mitigate massive negative tax consequences under these relief provisions.  So the IRS has just announced in Notice 2021-26 that if daycare FSA funds from 2020 would have been non-taxable if they could have been spent as intended in calendar year 2020, those funds brought forward to 2021 under enhanced grace period or carryover relief will not result in taxable reimbursements, even if total reimbursements end up exceeding $10,500 (half for married filing separately).  Likewise, daycare FSA funds that would have been non-taxable if they could have been spent as intended in calendar year 2021 will not be taxable if brought forward under enhanced grace period or carryover relief and spent in 2022, even if total reimbursements end up exceeding $5,000 (half for married filing separately).

Helpful examples are provided to clarify that employees might still end up with significant taxable income despite the relief provided in this notice if they are unable to incur expenses this year.  So it would be good for employers and employees to consider these examples when determining how much to contribute to a plan which might provide reimbursements during calendar year 2022.

• Example 1 shows how someone in a calendar year plan could be reimbursed $15,500 in calendar year 2021 with all of it being non-taxable ($5,000 enhanced carryover + $10,500 in new contributions, all reimbursed on qualifying daycare expenses incurred this year).
• Example 2 shows how someone in a non-calendar year plan that is unable to incur expenses in 2021 when the income exclusion is higher (and thus still has their entire $15,500 available on January 1, 2022) could end up in this particular example with $8,000 taxable income in 2022 (reportable on their April 2023 tax return).
  • The employee in this example could have been more careful in their election and reimbursements decisions for the plan year that began in 2022, perhaps saving any new contributions for 2023 expenses instead of using those on 2022 expenses.
• Example 3 shows how someone in a non-calendar year plan that elects $10,500 at the start of the plan year beginning in 2021 but is only reimbursed $5,000 in expenses this year should note that the $5,500 remaining balance on January 1, 2022, will count against their income exclusion limit for calendar year 2022.  That already exceeds the $5,000 limit, so they should be cautious about the tax consequences for reimbursements above the income exclusion limit in 2022.
  • In the example provided, they end up making election and reimbursements decisions in 2022 that result in $3,000 in taxable income, rather than saving their newer contributions for 2023 expenses.

IMA will continue to monitor regulator guidance and offer meaningful, practical, timely information.

This material should not be considered as a substitute for legal, tax and/or actuarial advice. Contact the appropriate professional counsel for such matters. These materials are not exhaustive and are subject to possible changes in applicable laws, rules, and regulations and their interpretations.