Dependent Care FSA Election Changes
By Brian Gilmore | Published January 17, 2023
Question: When can employees change their dependent care FSA election mid-year?
Short Answer: Although the Section 125 cafeteria plan irrevocable election rule is very strict, it is relatively easy to modify a dependent care FSA election because any change in use of daycare, change in a daycare provider, or change in an existing daycare provider’s cost generally will qualify as a permitted election change event.
General Rule: Section 125 Cafeteria Plan Irrevocable Election
Employees’ elections to pay the employee-share of the premium for health and welfare plan coverage on a pre-tax basis or make pre-tax FSA contributions are governed by Section 125 of the Internal Revenue Code. The Section 125 cafeteria plan rules are very strict when it comes to the irrevocability of employees’ elections.
That general rule under Section 125 is that all elections (including an affirmative or default election not to participate) must be:
a) made prior to the start of the plan year, and
b) irrevocable for the plan year unless the employee experiences a Section 125 permitted election change event.
The permitted election change events are set forth in Treas. Reg. §1.125-4. Most cafeteria plans provide a window of 30 days for an employee to make a mid-year election change upon experiencing a permitted election change event.
For more details:
Common Events That Permit Mid-Year Dependent Care FSA Election Change
Although the Section 125 cafeteria plan irrevocable election rule is very strict, it is relatively easy to modify a dependent care FSA election because most events that could prompt an employee to consider changing the election will qualify as a permitted election change event.
Common examples include:
Change in Daycare Provider
Where the employee changes daycare providers, this qualifies as cost change and/or a coverage change permitting employees to modify their dependent care FSA election accordingly.
Notes:
This permitted election change event applies even where the employee chooses to move the child to a new provider voluntarily.
Change in Daycare Cost
Where the employee’s cost of daycare changes, this qualifies as cost change permitting employees to modify their dependent care FSA election accordingly.
Notes:
This permitted election change event applies even where the employee decides to pay the daycare provider more (e.g., providing a raise to the nanny).
This permitted election change event applies even where the employee has different daycare costs due to a voluntary (or involuntary) change in employment schedule.
This permitted election change event does not apply where the daycare provider is a relative (related to the employee by blood or marriage).
Change in Use of Daycare
Where the employee starts or stops using daycare, this qualifies as a coverage change or other event permitting employees to modify their dependent care FSA election accordingly.
Notes:
This permitted election change event applies even where the employee has voluntarily chosen to change use of daycare.
An employee may use this permitted election change event to enroll in or increase the dependent care FSA election where the spouse begins to work or there is an increase in work hours, thereby creating or increasing reimbursable employment-related dependent care FSA daycare expenses.
An employee may use this permitted election change event to reduce or revoke the dependent care FSA election where a spouse stops working, there is a reduction in work hours, or a child reaches age 13 causing the reduction/loss of reimbursable dependent care FSA daycare expenses.
Dependent Care FSA Election Change: Prospective Effect
Where employees change their dependent care FSA election mid-year, the election change will be effective prospectively. As the Section 125 regulations put it, the mid-year change is “with respect to the remaining portion of the period of coverage, but only with respect to cash or other taxable benefits that are not yet currently available.”
In other words, the election change has no effect on amounts already contributed year-to-date. Any amounts already contributed remain available only for valid dependent care expenses incurred during the period of coverage. The Section 125 use-it-or-lose-it rule requires that any remaining unreimbursed funds after the end of the plan year (or earlier termination of participation) and any grace period and/or run-out period be forfeited to the plan.
There is no option for employers to make exceptions to these rules or directly or indirectly refund (even on a taxable basis) to employees any unreimbursed FSA amounts remaining following termination of participation or at the end of the plan year, plus any related grace period and/or run-out period (subject to any carryover). Engaging in this practice would risk disqualifying the entire Section 125 cafeteria plan if discovered by the IRS, potentially resulting in all elections becoming taxable to all employees.
For more details: FSA Experience Gains from Forfeitures.
Example:
Maverick and Penny have a daughter Amelia who attends an after-school program each day following elementary school.
Maverick makes a $5,000 dependent care FSA election at his employer Coronado Jets’ open enrollment period for the 2023 calendar plan year.
In June, Penny decides to quit working at the Hard Deck bar to spend more time at home with Amelia, which means Maverick and Penny will not have any eligible expenses going forward.
Maverick revokes his dependent care FSA election late in June after incurring $2,000 in daycare expenses year-to-date.
Result:
Maverick’s revocation of his dependent care FSA election is prospective in effect as of July 1 and does not affect his $2,500 year-to-date contributions or remaining $500 balance.
If Maverick does not incur any more eligible dependent care FSA expenses in the remainder of 2023, he will forfeit the remaining $500 balance.
Per the use-it-or-lose-it rule, Coronado Jets cannot refund the $500 dependent care FSA directly or indirectly to Maverick, even on a taxable basis.
Rare Exception: Doctrine of Mistake
IRS officials have consistently provided informal guidance stating that an employee’s cafeteria plan election may be corrected where there is “clear and convincing evidence” of a mistaken election. This approach is commonly referred to as the IRS “doctrine of mistake”.
Although the general rule is that employees’ cafeteria plan elections are irrevocable under Section 125, correcting an erroneous election under the doctrine of mistake is not treated as an impermissible mid-year election change. Rather, the employer is undoing the erroneous election (including an affirmative or default election not to participate) from ever occurring by replacing it retroactively with the election that the employee clearly intended.
One situation where it is appropriate for employers to consider utilizing the doctrine of mistake to undo an erroneous election is where the employee enrolls in the dependent care FSA despite have no qualifying dependents. In this case, it is possible for the employer to establish the requisite clear and convincing evidence that a mistake has occurred because the employee cannot possibly benefit from the election.
For more details: The IRS Doctrine of Mistake to Undo Erroneous Dependent Care FSA Elections.
Difficult Dependent Care FSA Eligible Expense Issues
For more details on situations where the qualifying status of dependent care expenses is difficult to determine, see our prior posts:
Summary
In a world where employees are constantly confounded by the Section 125 irrevocable election rule (and carrier limitations) prohibiting them from changing health and welfare plan and FSA pre-tax contribution elections, there is a silver lining. Employees can change their dependent care FSA election on a prospective basis in response to nearly any change in the employee’s daycare circumstances that could prompt the employee to desire to change their contributions. However, keep in mind that employees can change their dependent election on a prospective basis only, which can in some cases still result in forfeiture of prior contributions.
For more details on cafeteria plan compliance considerations, see our Newfront Section 125 Cafeteria Plan Guide.
Relevant Cites:
Treas. Reg. §1.125-4(c)(4):
Example (9).
(i) Employee A has one child, B. Employee A's employer, X, maintains a calendar year cafeteria plan that allows employees to elect coverage under a dependent care FSA. Prior to the beginning of the calendar year, A elects salary reduction contributions of $4,000 during the year to fund coverage under the dependent care FSA for up to $4,000 of reimbursements for the year. During the year, B reaches the age of 13, and A wants to cancel coverage under the dependent care FSA.
(ii) When B turns 13, B ceases to satisfy the definition of qualifying individual under section 21(b)(1) of the Internal Revenue Code. Accordingly, B's attainment of age 13 is a change in status under paragraph (c)(2)(iv) of this section that affects A's employment-related expenses as defined in section 21(b)(2). Therefore, A may make a corresponding change under X's cafeteria plan to cancel coverage under the dependent care FSA.
Treas. Reg. §1.125-4(f)(2):
(2) Cost changes.
…
(iv) Application to dependent care. This paragraph (f)(2) applies in the case of a dependent care assistance plan only if the cost change is imposed by a dependent care provider who is not a relative of the employee. For this purpose, a relative is an individual who is related as described in section 152(a)(1) through (8), incorporating the rules of section 152(b)(1) and (2).
Treas. Reg. §1.125-4(f)(6):
Example (5).
(i) Employee A is married to Employee B and they have one child, C. Employee A's employer, M, maintains a calendar year cafeteria plan that allows employees to elect coverage under a dependent care FSA. Child C attends X's on site child care center at an annual cost of $3,000. Prior to the beginning of the year, A elects salary reduction contributions of $3,000 during the year to fund coverage under the dependent care FSA for up to $3,000 of reimbursements for the year. Employee A now wants to revoke A's election of coverage under the dependent care FSA, because A has found a new child care provider.
(ii) The availability of dependent care services from the new child care provider (whether the new provider is a household employee or family member of A or B or a person who is independent of A and B) is a significant change in coverage similar to a benefit package option becoming available. Because the FSA is a dependent care FSA rather than a health FSA, the coverage rules of this section apply and M's cafeteria plan may permit A to elect to revoke A's previous election of coverage under the dependent care FSA, and make a corresponding new election to reflect the cost of the new child care provider.
Example (6).
(i) Employee D is married to Employee E and they have one child, F. Employee D's employer, N, maintains a calendar year cafeteria plan that allows employees to elect coverage under a dependent care FSA. Child F is cared for by Y, D's household employee, who provides child care services five days a week from 9 a.m. to 6 p.m. at an annual cost in excess of $5,000. Prior to the beginning of the year, D elects salary reduction contributions of $5,000 during the year to fund coverage under the dependent care FSA for up to $5,000 of reimbursements for the year. During the year, F begins school and, as a result, Y's regular hours of work are changed to five days a week from 3 p.m. to 6 p.m. Employee D now wants to revoke D's election under the dependent care FSA, and make a new election under the dependent care FSA to an annual cost of $4,000 to reflect a reduced cost of child care due to Y's reduced hours.
(ii) The change in the number of hours of work performed by Y is a change in coverage. Thus, N's cafeteria plan may permit D to reduce D's previous election under the dependent care FSA to $4,000.
Example (7).
(i) Employee G is married to Employee H and they have one child, J. Employee G's employer, O, maintains a calendar year cafeteria plan that allows employees to elect coverage under a dependent care FSA. Child J is cared for by Z, G's household employee, who is not a relative of G and who provides child care services at an annual cost of $4,000. Prior to the beginning of the year, G elects salary reduction contributions of $4,000 during the year to fund coverage under the dependent care FSA for up to $4,000 of reimbursements for the year. During the year, G raises Z's salary. Employee G now wants to revoke G's election under the dependent care FSA, and make a new election under the dependent care FSA to an annual amount of $4,500 to reflect the raise.
(ii) The raise in Z's salary is a significant increase in cost under paragraph (f)(2)(ii) of this section, and an increase in election to reflect the raise corresponds with that change in status. Thus, O's cafeteria plan may permit G to elect to increase G's election under the dependent care FSA.
Treas. Reg. §1.125-2(a)(4):
(4) Exceptions to rule on making and revoking elections. If a cafeteria plan incorporates the change in status rules in §1.125-4, to the extent provided in those rules, an employee who experiences a change in status (as defined in §1.125-4) is permitted to revoke an existing election and to make a new election with respect to the remaining portion of the period of coverage, but only with respect to cash or other taxable benefits that are not yet currently available.
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).
Brian Gilmore
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.
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