Exploring Dependent Care Assistance Programs

March 5, 2025

Caitlin Hillenbrand, Associate Director, Benefits Compliance

Many employers understand the benefits of offering a dependent care assistance program (“DCAP”) flexible spending account to their employees. DCAPs are a valuable tool for attracting and retaining top talent while providing significant tax benefits for both parties involved. This article will explore the advantages of DCAPs and the reasons why employers not presently offering this benefit should potentially reconsider.

Employer Action Items

• Consult with Experts: Talk to tax and benefits consultants to learn about the tax implications and administrative requirements of offering this type of account.
• Employee Surveys: Understand your employees’ needs through surveys or informal conversations to assess if a DCAP would be a valued benefit.
• Plan Design: Determine the specifics of your plan, such as contribution limits, eligible expenses, and enrollment procedures.
• Vendor Selection: If you decide to move forward with offering a DCAP, choose a reputable vendor to manage it. Consider factors such as ease of use, customer service, and cost.
• Train HR Staff: Your HR team will need to understand DCAPs inside and out so they can accurately answer employee questions and manage the program effectively.
• Compliance: Ensure the plan meets IRS requirements, stays in compliance with all regulations, and does not discriminate in favor of highly compensated employees.
• Communicate the Plan: Once the plan is in place, communicate it clearly to your employees. Make sure they understand how it works, the benefits, and how to enroll.
• Monitor and Evaluate: After implementation, monitor the uptake and utilization of the DCAP and gather feedback from employees in the event changes need to be made in the future. Make sure nondiscrimination testing is conducted, and the plan passes.

Summary

Internal Revenue Code (“Code”) Section 129 allows employers to provide dependent care assistance benefits for their employees on a tax-free basis. This is done through what is known as a Dependent Care Assistance Program (“DCAP”) or a Dependent Care Flexible Spending Account (“DC FSA”). Typically, employees fund these accounts with money from their paychecks on a pre-tax basis. For married employees filing a joint tax return or unmarried employees, the annual limit is $5,000 (this is a joint limit for married spouses, which means that spouses filing jointly may not each claim $5,000 in DCAP benefits). However, this figure is halved to $2,500 for married employees opting for separate tax filings. These dollar limits are not indexed for inflation, so they do not change from year to year. 

To ensure the DCAP account benefits remain non-taxable, certain conditions must be met:

• The expenditure must be specifically for the care of one or more qualifying individuals, which includes:
  • The taxpayer’s dependent child who has not attained age 13;
  • The taxpayer’s spouse who is mentally or physically incapable of self-care and who has the same principal place of abode as the taxpayer for more than half of the year; or
  • A dependent of the taxpayer who is mentally or physically incapable of self-care and who has the same principal place of abode as the taxpayer for more than half of the year.
• The expense must be incurred to facilitate gainful employment for the employee (and the employee’s spouse, if relevant).

Employees can request reimbursement from their DCAP account when they have eligible dependent care costs, which allow the employee to work. Significantly, a DCAP can only be used for eligible dependents, for example, a child under age 13 or a spouse or elder dependent who is physically or mentally incapable of self-care.

Some common DCAP qualifying expenses include, but are not limited to, the following:

• Assisted living
• Day Camp
• Daycare
• Preschool
• After-care or before-school care for school (subject to certain conditions)
• Backup or emergency care
• Babysitter (subject to certain conditions)

It is mandatory for employers offering DCAPs to have a written plan document outlining the specifics of the dependent care assistance benefits in compliance with the Code.  Employers have some flexibility in designing their DCAPs so long as they are not less restrictive than Code Section 129. Moreover, employers have the responsibility to inform their employees about the availability and terms of the DCAP. In addition to complying with Code Section 129, DCAPs that allow employees to make pre-tax contributions are subject to the Code Section 125 rules for cafeteria plans, including some of the rules that apply to health FSAs. Employers can choose to contribute to employees’ DCAP accounts as well, but they must follow certain rules to avoid discrimination.

Due to the rules of Section 125, employees generally cannot make changes to their DCAP during a plan year unless an exception applies. Importantly, DCAPs have a “use it or lose it” rule – any money left in the account by the end of the coverage period will typically be lost. However, the IRS does allow employers to design their DCAP with an extended deadline, or grace period, of 2.5 months after the end of a plan year to use DCAP funds. A DCAP is only allowed to cover eligible care expenses for dependents that were incurred during the plan’s coverage period, which may include a grace period if available. As DCAPs are not subject to the uniform coverage rule, a DCAP can restrict the reimbursement of eligible costs to the amount that has been deposited into the employee’s DCAP account at the time of the reimbursement request, taking into account any amounts already reimbursed. All employee requests for DCAP reimbursements must be substantiated with information from a third party.

Federal tax laws set forth the non-discrimination standards on DCAPs, which are meant to prevent benefits that favor highly compensated employees (“HCEs”). If a DCAP is discriminatory, HCEs will be taxed on the benefits received; however, it will not affect non-HCEs benefits. Discriminatory benefits under a DCAP are disclosed as wages in Box 1 of an HCE’s Form W-2. To avoid these consequences to the employer’s HCEs, it is essential for the DCAP to pass the four non-discrimination tests under Code Section 129.

Notably, because a DCAP is not a group health plan and is simply an account that reimburses employees for their dependent care expenses, DCAPs are typically not subject to the Employee Retirement Income Security Act (“ERISA”)^[1], the Consolidated Omnibus Budget Reconciliation Act (“COBRA”), the Affordable Care Act (“ACA”), or the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”).

Benefits of Offering a DCAP for Both the Employee and Employer

• Tax Savings: Contributions to a DCAP are made pre-tax, reducing the employee’s taxable income and using pre-tax dollars for eligible dependent care expenses. At the same time, employers save on payroll taxes as DCAP contributions are not subject to Social Security and Medicare taxes.
• Employee Satisfaction: Offering a DCAP can increase employee satisfaction by helping them better manage their dependent care costs and providing employees with a convenient and cost-effective way to take care of their dependents.
• Employee Retention: Providing a DCAP can be an attractive benefit for employees with dependents, which could aid in employee retention.
• Recruitment Advantage: Having a DCAP can make a workplace more appealing to potential employees, giving employers a competitive edge in recruitment.
• Flexibility: DCAPs are not just for childcare expenses. They can also be used for elder care or for dependents with special needs, offering flexibility for diverse employee needs.
• Increased Productivity: When employees have reliable childcare or dependent care in place, they can often be more focused and productive at work.
• Budget Planning: DCAP funds are determined at the beginning of the plan year, assisting employees in budgeting for care expenses.
• Support Employees’ Work-Life Balance: This benefit helps support work-life balance for employees by easing the financial burden of dependent care.

In conclusion, offering a DCAP to employees not only provides substantial tax advantages for both parties but also promotes a supportive work environment, resulting in increased staff retention, productivity, and overall satisfaction.

Additional Resources

• I.R.S., Publication 503: Child and Dependent Care Expenses (2023).

[1] An ERISA-exempt DCAP could become an ERISA plan in two rare circumstances:

(1) If the DCAP requires participating employees to select a specific dependent care provider, it could be classified as an ERISA plan. The Department of Labor (“DOL”) may consider the DCAP as offering a daycare service, a benefit included in the ERISA definition of an employee welfare benefit plan, thus transforming the DCAP into an ERISA plan.

(2) Alternatively, if the DCAP provides reimbursements for other benefits enumerated in the ERISA plan definition, it could become an ERISA plan. These include assistance for persons with disabilities (which would qualify as disability benefits) or for home-based or other non-institutional nursing services (which would qualify as medical benefits).