IRS clarifies taxable income cap for dependent care expenses

Some provisions in federal COVID relief legislation created confusion about reimbursement limits for the Dependent Care Assistance Program. Earlier this year, the Internal Revenue Service clarified those amounts in its Notice 2021-26.

Under normal circumstances, employees may be reimbursed up to $5,000 per calendar year (up to $2,500 for married filing separate) without including it in their taxable income. If an employee has funds left over and takes advantage of the following year's grace period, any amount reimbursed during that grace period above $5,000 for the year must be reported as taxable income.

IRS Notice 2021-26 provides an exception to this rule. Any unused funds from 2020 that carry over into 2021 -- or unused funds from 2021 that carry over into 2022 -- will not count toward the annual maximum that may be reimbursed on a tax-favored basis.

An example: An employee elected $5,000 for plan year 2020 but did not incur any childcare expenses. The full unused $5,000 carried over for use in 2021. The employee then elected to contribute the maximum $10,500 for plan year 2021. The employee incurs $15,500 in expenses and is reimbursed $15,500 in 2021. The full $15,500 is excluded from the employee's 2021 taxable income per IRS guidelines. Similarly, if an employee elects to contribute the full $5,000 maximum for plan year 2022, they may be reimbursed $5,000 plus any additional amounts that carried over from 2021 without increasing their taxable income.

Questions about flex plan rules and tax impacts may be directed to the payroll, benefits and tax office,