Benefits Insights

The One Big Beautiful Bill Act (OBBBA) increased the annual dependent care FSA contribution limit from $5,000 to $7,500 (or $3,750 for married individuals filing separately). This amount has not been increased in 25 years, and anyone with kids in daycare knows that $5,000 doesn’t go very far today.  While this is a welcome update for many employees, it comes with important compliance and strategic considerations for employers. First, if you increased the limit for your employees, you must amend your dependent care assistance plan, which is normally part of a company’s Section 125 plan, by December 31, 2026, to adopt the new limit. Without this amendment, employees cannot take advantage of the higher contribution cap.

While the increase sounds positive for employees, it can create challenges with nondiscrimination testing—specifically the 55% Average Benefits Test. This test requires that non-highly compensated employees (non-HCEs) receive at least 55% of the benefits provided to highly compensated employees (HCEs). When the limit jumps to $7,500, HCEs are more likely to contribute the maximum, which can skew the ratio and increase the risk of failing the test. If you have had problems passing this test in the past, you will likely continue to have problems and potentially experience an even greater difference in the ratio.

OBBBA also enhances the Child and Dependent Care Tax Credit, offering a 50% credit for eligible expenses for families with adjusted gross income (AGI) under $43,000, with the credit gradually phasing down above that threshold. This percentage was previously only 35%. Historically, most employees were better off contributing to their employer’s dependent care FSA than taking the tax credit.  After OBBBA, it may be more advantageous for lower- and middle-income families to take the tax credit instead of contributing to a dependent care FSA. If fewer non-HCEs participate, even employers that previously passed the 55% Average Benefits Test may find it harder to pass going forward.

Now that open enrollment is behind you, this is the perfect time to run a preliminary nondiscrimination test. Doing so early allows you to spot potential compliance issues and take corrective action before year-end. If the test suggests your plan may fail, you can limit HCE contributions to a level that will let you pass the test. Failing the test without correction means all dependent care FSA contributions made by HCEs become taxable, requiring adjustments to W-2s and payroll. Acting proactively avoids the administrative burden of retroactive corrections and prevents unexpected tax consequences for your executives.

If you have any questions or need assistance amending your plan document, please contact any member of our Employee Benefits team.