If a participant is reimbursed more than $5K in a calendar year for dependent care FSA expenses due to an extended grace period or carryover provision, is the amount above $5K subject to taxation?

In short, likely yes.

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).

That said, the Consolidated Appropriations Act of 2021 (CAA) 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.

The IRS released Notice 2021-15, 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 taken into account in determining the annual limit applicable for the following year. Meaning, 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, despite having the ability for a carryover or extended grace period, neither the CAA nor Notice 2021-15 amend the annual DCAP limit permitted to be excluded from income. So any amount reimbursed over $5,000 in a calendar year will seemingly be subject to taxation. Let’s look at an example:

Robert had $1,000 in unused DCAP contributions in 2020. His employer chooses to adopt a carryover feature for the DCAP permitting the total unused account balance to be carried over into the following plan year. For 2021, Robert elects $5,000 in salary reductions for his DCAP. During 2021, Robert incurs and is reimbursed for $6,000 in DCAP expenses. When Robert files his tax return, he is only able to exclude from taxable income a maximum of $5,000 in DCAP expenses. The other $1,000 will likely be treated as taxable income.

While the DCAP relief allows participants to forgo forfeiting year-end account balances, any reimbursements over the annual limit will likely be treated as taxable income, without any further guidance. If employers choose to implement this relief, they should be sure to communicate that amounts over $5,000 reimbursed in a calendar year will likely be taxable income.