Dependent Care FSA Limit Challenges
By Brian Gilmore | Published September 21, 2023
Question: What are the common issues for employers and employees caused by the $5,000 calendar year dependent care FSA limit?
Short Answer: The dependent care FSA limit presents multiple challenges for non-calendar plan years, short plan years, married employees, mid-year new hires, and W-2 reporting.
General Rule: $5,000 Dependent Care FSA Calendar Year Limit
Internal Revenue Code §129 sets the annual dependent care FSA contribution limit at $5,000 (or $2,500 for married individuals filing separately). The limit is based on the employee’s “taxable year.” In almost all situations, the employee’s taxable year is the calendar year.
Unfortunately, Congress did not index the $5,000 dependent care FSA contribution to inflation when it established the cap in 1986. Only an act of Congress can modify the $5,000 statutory limit. As a result, other than the brief blip where ARPA temporarily increased the limit in 2021, the dependent care FSA limit has remained constant at $5,000 its entire multi-decade lifespan.
For more details: Why the Dependent Care FSA Limit is Only $5,000
$5,000 Limit Challenges: Non-Calendar Dependent Care FSA Plan Year
The $5,000 annual dependent care FSA limit applies on a calendar year basis—regardless of the dependent care FSA plan year set by the employer. Employers with a non-calendar plan year for their health plan will often align all benefits to correspond with that same non-calendar plan year. This approach presents dependent care FSA limit coordination challenges for both employers and employees.
The Green Dragon Inn maintains a dependent care FSA with a July 1 – June 30 plan year.
Rosie Cotton has a child Elanor mid-year and enrolls in the dependent care FSA with a $5,000 election upon her return to work in January 2024.
Rosie contributes $5,000 to the dependent care FSA for the remainder of the plan year (from January – June 2024).
Rosie has reached the $5,000 calendar year limit by the end of the plan year (June 30, 2024).
Rosie cannot enroll in the dependent care FSA at open enrollment for the July 1, 2024 – June 30, 2025 plan year because she has already reached the CY 2024 limit.
Rosie cannot enroll in the dependent care FSA in the middle of the plan year as of January 2025 without experiencing a permitted election change event.
If Rosie enrolls in the dependent care FSA at open enrollment for the plan year beginning July 1, 2025 with a $5,000 election, she will contribute only $2,500 in CY 2025 (because contributions must be taken ratably over the course of the plan year and cannot be accelerated).
Rosie will only return to taking full advantage of the $5,000 limit in CY 2026 if she again elects $5,000 at open enrollment for the plan year beginning July 1, 2026.
There are multiple potential lessons from this example (which would apply in the same manner if Rosie were a new hire in January). The first is that ideally Rosie would plan in advance and elect only $2,500 for the period from January – June 2024 (i.e., through the end of the plan year) to largely avoid this issue. However, many employees will not be aware of this consideration.
This will also present a significant employer challenge to properly communicate and administer this plan year/calendar year limit dichotomy. An unsuspecting employer in the example above could easily fall into the trap of permitting Rosie to elect $5,000 at open enrollment for the plan year beginning July 2024, thereby creating excess contributions in CY 2024 that would need to be corrected.
Another lesson is how these situations can create persistent problems that extend over the course of multiple years. In Rosie’s case, she would not be able to take advantage of the full $5,000 calendar year limit in 2025 without experiencing a permitted election change event. Although it is relatively easy to find a permitted election change event for dependent care FSA purposes, employees relying on that ability to change dependent care FSA elections mid-year would frustratingly have to continue doing so year-after-year to reach the $5,000 goal.
For more details: Dependent Care FSA Election Changes
The only clear way to solve for these issues is to move the dependent care FSA to a calendar plan year. This does not require the employer to change their health plan year, cafeteria plan year, or health FSA plan year. The cafeteria plan rules specifically provide that the dependent care FSA can have a separate period of coverage from the other benefits offered under the cafeteria plan. In the example above, the Green Dragon Inn could continue to offer a July 1 plan year for its health and welfare plan, cafeteria plan, and health FSA, while moving its dependent care FSA plan year to the calendar year.
Bottom Line: Even employers that maintain a non-calendar plan year for other benefit purposes should strongly consider moving the dependent care FSA period of coverage to the calendar year to avoid thorny issues associated with the calendar year dependent care FSA limit.
$5,000 Limit Challenges: Dependent Care FSA Short Plan Year
Unlike the health FSA, there is no requirement to cap dependent care FSA elections at a prorated limit for a short plan year. The $5,000 dependent care FSA maximum (or $2,500 if married filing separately) is based solely on the calendar year.
Nonetheless, best practice generally is to impose a prorated dependent care FSA contribution limit for a short plan year. Otherwise, it can be difficult to monitor and prevent employees from exceeding the $5,000 calendar year maximum.
Gaffer Gardening maintains a dependent care FSA with an April 1 – March 31 plan year.
Samwise elects to contribute $5,000 to the dependent care FSA at the open enrollment for the plan year beginning April 1, 2024 to pay for daycare costs for his growing family.
Gaffer Gardening decides at the next open enrollment to move to a calendar year dependent care FSA to avoid complications.
Gaffer Gardening will have a short plan year from April 1, 2025 – December 31, 2025 to transition to the calendar plan year as of January 1, 2026.
If Gaffer Gardening imposes a prorated $3,750 limit for the short transitional plan year from April – December, Samwise cannot exceed the $5,000 limit for CY 2025.
If Gaffer Gardening does not prorate the $5,000 limit for the short transitional plan year, they would need to carefully monitor whether employees such as Samwise would exceed the $5,000 calendar year limit in 2025 based on the dependent care FSA contributions from January – March.
Bottom Line: Prorating the contribution limit for the short plan year avoids unnecessary administrative burdens for the employer and third-party administrator in monitoring contributions from the end of the previous plan year that overlaps into the same calendar year as the short plan year.
For more details: Short Plan Year Considerations
$5,000 Limit Challenges: Coordinating Dependent Care FSA Contributions with Spouse
For married couples filing jointly, the $5,000 calendar-year limit applies for both spouses combined. Accordingly, both spouses cannot contribute the full $5,000 amount to each of their employer-sponsored dependent care FSAs. Married couples need to coordinate their dependent care FSA elections with their respective employer offerings to ensure they do not exceed the combined $5,000 maximum.
For more details: Dependent Care FSA Issues for Married Couples
$5,000 Limit Challenges: New Hires with Previous Dependent Care FSA Contributions
The dependent care FSA limit is a universal limit across all employers over the course of the calendar year. Accordingly, new hires making a mid-year dependent care FSA election will need to take into account all contributions made with previous employers in the calendar year to avoid exceeding $5,000.
Employees are generally familiar with this process on the 401(k) side, which imposes the same universal calendar limit for employee deferrals. However, because the health FSA salary reduction contribution limit is specific to each plan for unrelated employers, this can become a point of confusion for employees.
Where employees mistakenly exceed the $5,000 limit spread over two or more unrelated employers in the same calendar year, the employee will report the excess when filing their individual tax return (Form 1040). As part of the individual tax return, the employee will complete Form 2441. The Form 2441 will compute the amount of any excess dependent care FSA contributions, which must be reported as taxable income on the Form 1040 by writing “DCB” (dependent care benefits) next to Line 1. There is no penalty associated with this process. The excess amounts are merely converted to taxable income. The employee does not lose the excess contribution.
Frodo begins 2023 working for Mithrandir Adventures, Inc. from January through September.
In October 2023, Frodo takes a new job with Elrond Excursions, Inc.
Prior to changing jobs, Frodo contributed to Mithrandir’s 401(k) ($16,875), health FSA ($2,287.50), and dependent care FSA ($3,750).
Upon starting his new job with Elrond, Frodo can contribute up to the full $3,050 salary reduction contribution limit to the health FSA.
Frodo’s contribution limits to the Elrond 401(k) and dependent care FSA are reduced by his year-to-date contributions with his prior employer.
Frodo can defer up to $5,625 to the Elrond 401(k) for the remainder of 2023.
Frodo can contribute up to $1,250 the Elrond dependent care FSA for the remainder of 2023.
$5,000 Limit Challenges: Form W-2 Reporting with Grace Period and/or Run-Out Period
The Form W-2 instructions direct employers to report in Box 10 the total dependent care benefits paid or incurred under a dependent care assistance program for the employee. For a dependent care FSA, the amount reported is the total amount of cash reimbursement furnished to the employee during the calendar year.
This presents a challenge because virtually all dependent care FSAs have a run-out period to submit claims incurred during the plan year, and many offer a grace period to incur claims for the 2½-month period following the end of the plan year.
For more details: The Dependent Care FSA Grace Period
IRS guidance addresses this issue by providing that employers that do not know the actual total amount of cash reimbursement at the time the Form W-2 prepared (e.g., because there are unreimbursed dependent care FSA contributions subject to a grace period and/or run-out period) may report a reasonable estimate of the total amount on the Form W-2. The guidance permits employers to rely on the amount contributed by the employee to dependent care FSA (plus any employer matching contributions) as a reasonable estimate for this purpose.
Bag End Bagels sponsors a calendar plan year dependent care FSA with a grace period through March 15 of the subsequent year.
Meriadoc contributes $5,000 to the dependent care FSA for 2024.
At the end of 2024 he has claimed $4,500 from the dependent care FSA, with a $500 balance remaining into the grace period at the start of 2025.
Bag End Bagels may report the $5,000 amount contributed to the dependent care FSA in Box 10 of Meriadoc’s 2024 Form W-2, even though at the time of the Form W-2 he has been reimbursed for only $4,500.
$5,000 Limit Challenges: Coordinating with Employer-Paid Dependent Care Assistance
The Form W-2 Instructions direct employers to include in Box 10 all forms of dependent care assistance provided, including the fair market value of benefits provided in kind by the employer, any amounts paid directly by the employer to a daycare facility, and the benefits from the dependent care FSA. In many situations, the dependent care FSA is the only dependent care assistance provided by the employer, resulting in a relatively simple reporting obligation.
However, employers may provide dependent care assistance in a variety of other manners. One example would be employer contributions to the dependent care FSA or payments made directly to a childcare center. This could be for regular daycare purposes or as backup arrangement where the employee’s standard daycare is not available. It could also be employer-paid (or subsidized) on-site dependent care services. These amounts paid by the employer are all included in Box 10 of the employee’s Form W-2.
In some situations, employers will provide dependent care assistance payments through a Lifestyle Spending Account (LSA). In those cases, the dependent care assistance through the LSA will also be reported in Box 10. Although utilizing the LSA will remove the tax advantage potentially available for the assistance because LSA benefits are always taxable, that approach is still permitted. Where employees are already contributing to the dependent care FSA up to the $5,000 limit, the LSA approach will not cause any tax disadvantages because the employee was already excluding the maximum through the dependent care FSA.
For more details:
Where an employee is participating in the dependent care FSA and receiving employer-paid dependent care assistance through another manner (e.g., direct payment to a backup childcare service), the total dependent care assistance provided may exceed the $5,000 limit. In that case, the Form W-2 Instructions and IRS Publication 15-B direct the employer to include the full amount in Box 10, even if that exceeds $5,000. Any amount in excess of $5,000 must be included in the employee’s taxable income in Boxes 1, 3, and 5 of the Form W-2.
Saruman provides a generous benefits package to attract talent to his growing Uruk-Hai, Inc.
Uruk-Hai offers a dependent care FSA as well as an employer-paid benefit whereby the company offers to directly pay the cost for a month of a child’s care at any facility chosen by the employee.
In 2024, Lurtz is an employee who contributes $5,000 to the dependent care FSA, and he has the company directly pay his daycare provider $1,000 for one month of services.
Uruk-Hai, Inc. must report $6,000 in dependent care assistance in Box 10 of Lurtz’s 2024 Form W-2 ($5,000 from the dependent care FSA, $1,000 from the employer payment to his provider).
The $1,000 amount in excess of the $5,000 excludible limit must be included in Lurtz’s taxable income and reported in Boxes 1, 3, and 5 of the Form W-2.
(2) Limitation of exclusion.
(A) In general. The amount which may be excluded under paragraph (1) for dependent care assistance with respect to dependent care services provided during a taxable year shall not exceed $5,000 ($2,500 in the case of a separate return by a married individual).
Prop. Treas. Reg. §1.125-5(e)(3):
(3) Separate period of coverage permitted for each qualified benefit offered through FSA. Dependent care assistance, adoption assistance, and a health FSA are each permitted to have a separate period of coverage, which may be different from the plan year of the cafeteria plan.
Box 10—Dependent care benefits (not applicable to Forms W-2AS, W-2CM, W-2GU, or W-2VI).
Show the total dependent care benefits under a dependent care assistance program (section 129) paid or incurred by you for your employee. Include the fair market value (FMV) of care in a daycare facility provided or sponsored by you for your employee and amounts paid or incurred for dependent care assistance in a section 125 (cafeteria) plan. Report all amounts paid or incurred (regardless of any employee forfeitures), including those in excess of the $5,000 exclusion. This may include (a) the FMV of benefits provided in kind by the employer, (b) an amount paid directly to a daycare facility by the employer or reimbursed to the employee to subsidize the benefit, or (c) benefits from the pre-tax contributions made by the employee under a section 125 dependent care flexible spending account. Include any amounts over your plan’s exclusion in boxes 1, 3, and 5. For more information, see Pub. 15-B.
An employer that amends its cafeteria plan to provide a grace period for dependent care assistance may continue to rely on Notice 89-111 by reporting in box 10 the salary reduction amount elected by the employee for the year for dependent care assistance (plus any employer matching contributions attributable to dependent care).
Exclusion from wages.
You can exclude the value of benefits you provide to an employee under a DCAP from the employee's wages if you reasonably believe that the employee can exclude the benefits from gross income.
An employee can generally exclude from gross income up to $5,000 ($2,500 if married filing separately) of benefits received under a DCAP each year.
Report the value of all dependent care assistance you provide to an employee under a DCAP in box 10 of the employee's Form W-2. Include any amounts you can't exclude from the employee's wages in boxes 1, 3, and 5. Report in box 10 both the nontaxable portion of assistance (up to $5,000) and any assistance above that amount that is taxable to the employee.
If line 26 is more than zero, you have taxable dependent care benefits. Include this amount in the total on Form 1040 or 1040-SR, line 1; or Form 1040-NR, line 1a, whichever applies. Enter “DCB” in the space to the left of that line to show that taxable dependent care benefits are included in that amount.
The notice states that in a cash reimbursement arrangement, the amount reported on Form W-2, Wage and Tax Statement, is the total amount of cash reimbursement furnished to the employee during the calendar year. However, if the employer does not know the actual total amount of cash reimbursement at the time the Form W-2 is prepared, the employer may report a reasonable estimate of the total amount on Form W-2. Notice 89-111 states that for a salary reduction arrangement under a § 125 cafeteria plan, the amount electively contributed by an employee for the year for dependent care assistance (plus any employer matching contributions attributable thereto) will be considered a reasonable estimate.
An employer that amends its cafeteria plan to provide a grace period for dependent care assistance may continue to rely on Notice 89-111, by reporting in Box 10 of Form W-2 the salary reduction amount elected by the employee for the year for dependent care assistance (plus any employer matching contributions attributable thereto).
Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).
Lead Benefits Counsel, VP, Newfront
Brian Gilmore is the Lead Benefits Counsel at Newfront. He assists clients on a wide variety of employee benefits compliance issues. The primary areas of his practice include ERISA, ACA, COBRA, HIPAA, Section 125 Cafeteria Plans, and 401(k) plans. Brian also presents regularly at trade events and in webinars on current hot topics in employee benefits law.Connect on LinkedIn