With the recent passage of the budget reconciliation legislation (H.R.1), the annual contribution limit for dependent care flexible spending accounts (DCFSAs) will increase effective January 1, 2026. What are the tax consequences if our company chooses to adopt such an increase for our Internal Revenue Code (IRC) section 129 dependent care assistance program? And how does the IRC section 21 dependent care tax credit affect this decision?
Increasing the maximum pre-tax contributions employees can make to a DCFSA, as allowed by H.R.1, may cause the DCFSA to be discriminatory under IRC section 129. This is because it is likely that highly compensated employees (HCEs) will utilize the increase more than lower-paid employees. If that occurs, HCEs may need to pay taxes on their entire DCFSA contribution amount.
In addition, H.R.1 broadens the IRC section 21 dependent care tax credit. Because the tax credit often benefits lower- and middle-income employees the most, these employees may choose not to increase their contributions to a DCFSA — making it even more likely that the DCFSA would be considered “discriminatory.”
A company considering an increase in its DCFSA maximum annual contribution should consider conducting projected non-discrimination testing to assess the potential for failure and the resulting tax consequences for HCEs.
The IRS offers two potential ways for employees to pay dependent care expenses with certain tax benefits or advantages:
Pre-tax contributions to a DCFSA may lower an employee’s taxable income, whereas the child and dependent care tax credit may reduce the taxes due when an employee files a tax return.
Under IRC section 129, certain contributions to DCFSAs are excluded from employees’ gross income. H.R.1 increases the annual exclusion limit for DCFSAs from $5,000 to $7,500 if single or married and filing jointly (or, if married and filing separately, from $2,500 to $3,750). Note: Employers are not required to adopt this increase for their dependent care assistance programs. DCFSA limits are not indexed for cost-of-living adjustments, so they will not change again unless there is Congressional action.[1]
The dependent care tax credit, under IRC section 21, allows lower- and middle-income employees to take a credit against their tax liability when filing their income tax return. The credit is calculated based on income and a percentage of the amount paid for qualifying dependent care expenses that enable the employee or spouse to go to work, look for work or attend school. The qualifying dependent care expense limit remains $3,000 for one child and $6,000 for two or more dependents, with the 35% tax credit calculation on those expenses phasing out as adjusted gross income (AGI) increases. H.R.1 changed this tax credit in two ways beginning in 2026:
Choosing between a DCFSA and the dependent care tax credit depends on an employee’s specific financial situation, including income level and dependent care expenses. While an employee may use both the DCFSA and the tax credit, the same expenses cannot be claimed for both. Note: Employers should not offer advice on the best option for individual employees. Instead, employees are encouraged to seek advice from qualified tax professionals.
For HCEs to be able to exclude from gross income dependent care assistance up to the maximum allowable amount, a DCFSA must not discriminate in favor of HCEs or certain shareholders or owners of the employer as to eligibility or benefits. All DCFSAs must pass three required benefits tests:
H.R.1 makes no changes to the DCFSA nondiscrimination rules, which means HCEs are unlikely to receive any tax benefit from the increased limits.
If an employer increases a DCFSA’s annual maximum, it may be harder for it to pass the 55% benefits test — the test that DCFSAs fail most often. This is because it is likely that HCEs will contribute more to their DCFSAs, as they have more disposable income to make such contributions and often their dependent care arrangements are more costly than those of lower-paid employees. Thus, the average DCFSA benefit for HCEs is likely to increase, while the average benefit for non-HCEs may remain stable or decrease, especially if they use the dependent care tax credit.
If a DCFSA fails any of the IRC section 129 nondiscrimination tests, all HCEs will have taxable imputed income equal to the entire amount they received for dependent care assistance. This amount will be imputed into their income and reported on their W-2s. While this taxation can be avoided by reducing HCE elections midyear before the DCFSA becomes discriminatory, if the plan allows, such a correction will result in lower tax-favored contribution amounts for HCEs. In addition, each HCE’s gross income will increase by the amount of the corrected election amount, and that amount will be subject to income tax and withholding. Thus, HCE expected tax savings will be reduced.
