Stimulus Measure Raises 2021 Dependent Care FSA Limits
For calendar year 2021, the dependent care flexible spending account (FSA) pretax contribution limit increases to $10,500 (up from $5,000) for single taxpayers and married couples filing jointly, and to $5,250 (up from $2,500) for married individuals filing separately. The provision raises the exclusion limits for the plan year beginning after Dec. 31, 2020 and before Jan. 1, 2022
Employers may also allow employees to prospectively change their health or dependent care FSA contribution rates during 2021 without experiencing a permitted election-change event.
Employers wishing to offer optional FSA relief provisions must amend their Section 125 cafeteria plan to incorporate the changes. The amendment may be retroactive as along as it is adopted no later than the last day of the calendar year following the year in which the amendment is effective.
For 2021, the dollar limit for employee contributions to health flexible spending accounts (health FSAs), made pretax through salary reductions, remains unchanged at $2,750, the IRS announced on Oct. 27 when it issued Revenue Procedure 2020-45.
The limit also applies to limited-purpose FSAs that are restricted to dental and vision care services, which can be used in tandem with health savings accounts (HSAs).
For health FSA plans that permit the carryover of unused amounts, the maximum carryover amount for 2021 is $550, an increase of $50 from the original 2020 carryover limit.
The announcement arrived as many U.S. employers are preparing for their fall open enrollment period, during which employees select their benefit-contribution amounts for 2021.
The guidance also includes annual cost of living adjustments (COLAs), if any were made, for other employee benefit plans. For instance, for tax year 2021, the monthly limit for qualified transportation benefits remains $270, as is the monthly limit for qualified parking.
The IRS released 2021 HSA contribution limits in May, giving employers and HSA administrators plenty of time to adjust their systems for the new year. The individual HSA contribution limit will be $3,600 (up from $3,550) and the family contribution limit will be $7,200 (up from $7,100).
"Most enrollment materials have been finalized and distributed, so employers should leverage more immediate communication channels—such as e-mail, social media and websites—to get the word out," said Kim Buckey, vice president of client services at DirectPath, a benefits education, enrollment and health care transparency firm based in Burlington, Mass.
The health FSA contribution limit, originally imposed by the Affordable Care Act (ACA) and set at $2,500, "adjusts in $50 increments based on a complex cost-of-living calculation" for the preceding calendar year, explained Brian Gilmore, lead benefits counsel and vice president at ABD Insurance & Financial Services in San Mateo, Calif. "That measure was not sufficient in 2020 to increase by at least a $50 given the provision's requirement to round down to the next lowest multiple of $50."
The chart below shows the adjustment in health FSA contribution limits since 2019.
Health Flexible Spending Accounts (Includes limited-purpose FSAs)
Maximum salary deferral contribution
Source: IRS Revenue Procedure 2020-45.
Under rounding rules, benefit-contribution limits with annual COLAs remained unchanged if statutory price-increase thresholds are not met.
"The manner in which the IRS computes the cost-of-living adjustments for tax provisions is governed by the Internal Revenue Code," said William Sweetnam, legislative and technical director at the Employers Council on Flexible Compensation, which represents sponsors of account-based benefit plans. "Consequently, the result of low inflation is that limits may not increase every year, like this one."
While the IRS 2021 pretax maximum for employee health FSA contributions is $2,750, an employer may limit its employees to less than $2,750.
Employer Health FSA Contributions
If employers provide health care FSA contributions, this amount is in addition to the amount that employees can elect. Employees can elect up to the IRS limit and still receive the employer contribution in addition.
An employer may match up to $500 whether or not the employee contributes to a health FSA.
Starting at $501, employers may only make a dollar-for-dollar match to the employee’s contribution.
Gilmore advised that "employer contributions (including non-cashable flex credits) generally cannot exceed $500 per plan year for the health FSA to maintain excepted benefit status," which avoids making it subject to certain ACA and HIPAA requirements. Also, to remain an excepted benefit, health FSAs "should never be available to an employee who is not also eligible for the major medical plan (regardless of enrollment status)," he said.
Increased Carryover Cap
IRS Notice 2020-33, issued on May 12 as part of COVID-19 relief, raised the amount of funds that health FSA plans can carry over for 2020 to $550, up from $500. For 2021, the maximum carryover amount remains $550.
There are two options for FSA extensions; employers can adopt either or neither, but can't offer both:
Carryover. If an FSA plan has the carryover feature, participants can roll over up to $550 of unused FSA dollars to the next year but will forfeit any excess over $550 at year-end.
Grace period. An optional grace period gives employees an additional two-and-a-half months to incur new expenses using prior-year FSA funds. At the end of the grace period in mid-March, all unspent funds must be forfeited.
Any amount that rolls over into the new plan year does not affect the maximum limit that employees can contribute.
Also issued May 12, and for plan years ending before Dec. 31, 2020 only, IRS Notice 2020-29 allowed employers to amend a health or dependent care FSA plan to permit participants to "spend down" through year-end 2020 any remaining amounts that would otherwise be forfeited.
CARES Act Expands FSA-Eligible Purchases
As part of the Coronavirus Aid, Response and Economic Security (CARES) Act signed into law in March 2020, FSAs can now be used to pay for over-the-counter medications without a prescription—and the same expanded eligibility applies to HSAs and health reimbursement arrangements (HRAs). The coronavirus-related legislation also allows FSAs, HSAs and HRAs to pay for certain menstrual care products, such as tampons and pads, as eligible medical expenses. These are permanent changes and apply retroactively to purchases beginning Jan. 1, 2020.
Dependent Care FSAs
A dependent care FSA is a pretax benefit account used to pay for dependent care services such as day care, preschool, summer camps and nonemployer-sponsored before or after school programs. Funds may be used for expenses relating to children under the age of 13 or incapable of self-care who live with the account holder more than half the year.
The dependent care FSA maximum, which is set by statute and is not subject to inflation-related adjustments, is $5,000 a year for single taxpayers and married couples filing jointly, or $2,500 for married people filing separately. Married couples have a combined $5,000 limit, even if each has access to a separate dependent care FSA through his or her employer.
In addition, maximum contributions to a dependent FSA may not exceed these earned income limits:
For single account holders, the earned income limit is their salary excluding contributions to their dependent care FSA.
For married account holders, the earned income limit is the lesser of their salary excluding contributions to their dependent care FSA or their spouse's salary.
Employers can also choose to contribute to employees' dependent care FSAs. However, unlike with a health FSA, the combined employer and employee contributions to a dependent care FSA cannot exceed the IRS limits noted above.
Elder care may be eligible for reimbursement with a dependent care FSA if the adult lives with the FSA holder at least 8 hours of the day and is claimed as a dependent on the FSA holder's federal tax return.
Employer-funded parking and mass-transit subsidies are tax-exempt for employees. Using pretax income, employees can also pay their own mass-transit or workplace parking costs through an employer-sponsored salary deferral program.
These expenses include the value of mass-transit passes and van pooling services, and parking on or near the business worksite or a location from which employees commute to work by driving and then using mass transit.
The ability to pay transit expenses with pretax dollars, within the annual limit, "should be welcomed by employees with high commuter costs, such as those who rely on urban mass transit systems," said Danielle Capilla, director of employee benefits compliance at Alera Group, a network of insurance and financial services firms.
"On its own, the lack of a tax deduction for employers may seem like a disadvantage to offering these benefits, although some employers would still need to do so to stay competitive and to comply with state and local laws," said Bobbi Kloss, HR leader at Benefit Advisors Network (BAN), a consortium of health and welfare benefit brokers.
Shifting Account Funds from Mass Transit to Parking
In IRS Information Letter 2020-0024, released September 2020, the IRS was asked whether an employee could roll over unused transit benefits from a qualified mass transit account to a qualified parking account—an issue raised by employees who had formerly taken public transportation to commute but, due to COVID-19, are now driving to work and paying for parking.
The IRS responded that as long as the employer's plan includes both mass transit and parking accounts in its Section 132(f) qualified transportation program, and as long as the maximum limit of the accounts has not been exceeded, the employee could transfer funds from one account to the other.
In addition, unused compensation reduction amounts can be carried over to subsequent periods under an employer's plan and used for future commuting expenses, the IRS said, so long as the employee has made a valid compensation reduction election and remains employed by the employer. However, the qualified transportation plan rules do not allow refunds of qualified transportation benefits provided through a compensation reduction agreement.
For 2021, the maximum amount of an employer subsidy for qualified child-adoption expenses that can be excluded from an employee's gross income is $14,400, up from $14,300 for 2020.
Excludable reimbursements must be "necessary and reasonable expenses" related to adopting a child, according to the IRS. Qualified adoption expenses, however, don't include expenses that employees pay to adopt their spouse's child.
The amount excludable from an employee's annual earnings begins to phase out for employees with modified adjusted gross income higher than $216,660 (up from $214,520 for 2020) and is completely phased out for those with modified adjusted gross income of $256,660 (up from $254,520 or more).
Adoption Benefits (Annual limits)
Phase-out income thresholds:
Source: IRS Revenue Procedure 2020-45.
"Adoption benefits typically include some combination of financial assistance, information and referral services, and paid or unpaid leave," according to the Society for Human Resource Management's members-only toolkit Managing Adoption Assistance Benefits. "Adopting a child from foster care may cost about $2,500, domestic private adoptions can cost up to $40,000, and international adoptions can cost up to $50,000. Costs may include public or private agency fees, court costs, legal fees and counseling fees."
Employer programs can provide funds to reimburse adoption costs that exceed the annual limit, although employees will owe income taxes on any extra assistance they received.
Adoption Tax Credit vs. Employer Assistance
The tax code provides a separate income-tax credit for qualified adoption expenses. For 2020, the maximum credit is $14,400 per child—the same as the maximum nontaxable reimbursement by an employer's qualified adoption-assistance program—up from $14,300 per child in 2020. Tax credits larger than an employees' tax liability can be carried forward for up to five years.
Employees may take advantage of both the tax credit and the tax exclusion for employer reimbursements—but not for the same expenses.
Because employer-provided adoption aid is subject to FICA payroll taxes, some financial planners advise that high-income employees consider using the tax credit first, although employees who need upfront funds to pay expenses may benefit more from an employers' program.
For taxable years beginning in 2021, to qualify as a qualified small employer health reimbursement arrangement (QSEHRA), the arrangement must provide that the total amount of payments and reimbursements by employers for any year cannot exceed $5,300 for individual coverage or $10,700 for family coverage, Revenue Procedure 2020-45 states.
QSEHRA Coverage (Annual limits)
Source: IRS Revenue Procedure 2020-45.
QSEHRAs first became available in 2017 after the enactment of the 21st Century Cures Act. They allow small employers—those with fewer than 50 full-time or equivalent employees—to give their workers money tax-free to purchase individual health policies, which is not allowed with a traditional HRA or an HSA. The coverage can be purchased on an Affordable Care Act marketplace exchange or through an insurance broker.
As with a regular HRA or an HSA, QSEHRA funds can be used for out-of-pocket medical costs, and they can also be used to pay all or part of the plan premiums.
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