IRS Relaxes Rules on Dependent Care Flexible Spending Accounts
To provide flexibility for employees coping with the fallout from the Covid-19 virus, the IRS has issued new guidelines that allow employers to amend dependent care Flexible Spending Accounts (FSA)s, allowing workers to adjust dependent care plan contributions – including dropping contributions altogether.
Dependent care Flexible Savings Accounts (FSAs) are set up with an individual’s employer who has agreed to participate in such a program. Roughly 85% of employers with 500 or more employees offer them. In those cases, workers authorize their employers to withhold funds from their paychecks each pay period for deposit to an FSA. The worker pays for “qualified” expenses out-of-pocket, and then applies for reimbursement from the account administrator by completing a claim form with receipts or proof of payment attached.
Dependent care FSA funds can only be used for reimbursements that meet the IRS’s definition of an eligible dependent care service. (i.e., care necessary for the participant and/or spouse to earn an income). Qualified expenses include physical care, in-home care, daycare service, summer day camps, before- and after-school care, caregiver transportation, and fees associated with obtaining care. Expenses that do not qualify include overnight camps, housekeeping, music and sports lessons, and education (e.g., kindergarten, summer school, private school tuition, etc.).
The Covid-19 Connection
With millions of people currently out of work, dependent care has become an even more critical issue – perhaps even a looming liability – and a continuing burdensome expense for many American families. Families rely on childcare to facilitate their ability to work. Millions of others are responsible for the care of aging parents or disabled dependents. In short, workers who need care for children under age 13, or an adult incapable of self-care, who lives in their home and who can be legitimately claimed as a dependent on their federal tax form, may qualify for a dependent care FSA. Question is, in today’s Covid-19-plagued environment, how do workers spend FSA funds for dependent care if both their children’s school and/or their after-school facility is closed? The most obvious solution is to request that their employer stop deducting – or adjust – dependent care contributions. The new IRS guidelines make these requests possible… but do not require employer compliance.
In any event, FSAs in 2020 are more flexible for participants whose budgets have been upended by the Covid-19 pandemic. Under these revised (and probably temporary) IRS guidelines, employees can make mid-year changes – adjustments up or down – regarding their contribution amounts. But as before, no carryovers into the next dependent plan year are permitted.
Use It or Lose It
The primary benefit of a dependent care FSA is its tax treatment. All money contributed to the account by a worker is considered pretax, which means employees don’t pay federal, Social Security or Medicare taxes on contributions. (And employers benefit, too. They don’t have to pay Social Security and Medicare taxes on the portion of employee salaries set aside in FSAs.) This effectively reduces the amount of a participant’s income subject to taxation – a significant savings depending upon one’s tax bracket and the amount of the contribution.
However, the IRS does limit the amount of money per annum that a worker can contribute to a dependent care FSA. More specifically, dependent care FSA participants can automatically put away a specified amount of money from their paychecks to spend on child and other qualified dependent care. But there is a catch – a “use it or lose it” feature. Yep, all money in a dependent care FSA must be spent before the plan year ends. Unspent funds are forfeited to the employer. Each worker can contribute up to $2,500 of earned income per plan year to cover qualified dependent care, or $5,000 for workers who are married, filing jointly. If a worker and his/her spouse are divorced, only the parent who has custody of the child(ren) is eligible to use FSA funds for childcare. If a couple is still married, both must work and earn income to qualify for reimbursement (unless one spouse is disabled and unable to work). If not, money contributed to the account will be forfeited to the employer and applicable taxes will become due.
Before the IRS rule changes, account participants were not permitted to adjust their contributions mid-year except in specific circumstances, including if a school closes, if the employee shifts to working from home, a marriage or divorce, the birth of a child, or some qualifying event that added or subtracted a dependent or spouse. The new IRS guidance allows companies to amend their plans that allow workers to opt into, drop out of, or adjust their contributions mid-year. And to repeat, these new IRS guidelines apply only if the employer chooses to amend its FSA plan (it’s anticipated that most employers will adopt the IRS guidance quickly).
Regarding money already contributed in the plan year, it must still be spent on qualified programs for kids under age 13 and/or for older dependents unable to care for themselves. The agency’s rule changes regarding both dependent care and healthcare FSAs are part of a larger federal government effort to provide affected households “some maneuvering room” under tax rules due to a job loss and/or reduced cash flow. A companion adjustment was that federal filing deadlines and tax payments were also postponed – to July 15. More on the healthcare FSAs in a later blog.