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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.
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.
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.
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.
This permitted election change event applies even where the employee has voluntarily chosen to change use of daycare.
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.
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.
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:
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.
Written by: Brian Gilmore, January 17, 2023. Link to the original article can be found here.