DCAP Nondiscrimination Testing Problems After the $7,500 Increase
- Tom Seltz
- 3d
- 5 min read
Quick Answer
Although the Dependent Care Assistance Program (DCAP) maximum benefit increased to $7,500 for 2026, the nondiscrimination testing rules did not change. As a result, many employers are now failing the 55% Average Benefits Test. When that happens, Highly Compensated Employees (HCEs) can lose the tax-free treatment on discriminatory DCAP benefits unless corrective action is taken.
Why This Is Landing on Brokers’ Desks Right Now
If you are suddenly getting calls about DCAP testing failures, you are not alone. The jump from $5,000 to $7,500 gave employees more flexibility, but it also magnified a long-standing DCAP issue: participation imbalance.
Plans that passed comfortably for years are now failing because:
Highly Compensated Employees (HCEs) are electing closer to the maximum.
Non-HCE participation has not increased at the same pace.
The testing math did not adjust to account for the higher limit.
This often surfaces mid-year, after elections are locked in and expectations are set. That is when brokers are asked to explain the outcome and help employers manage both compliance and employee frustration.
The DCAP Core Requirement: The 55% Average Benefits Test
Dependent Care Assistance Programs are subject to nondiscrimination rules under Internal Revenue Code Section 129. One of the most common failure points is the 55% Average Benefits Test.
In plain English:
The average DCAP benefit for non-HCEs must be at least 55% of the average benefit for HCEs.
When HCE elections are high and non-HCE participation is low, the test can fail quickly. Because the test is looking at average elections, each person who declines participation in the DCAP lowers the average election.
The higher $7,500 limit increases that risk.
If the test is not satisfied, the plan is still treated as a DCAP for non-HCEs, but HCEs can lose the tax exclusion on discriminatory benefits, which then become taxable wages.
What Can Still Be Done Mid-Year
When a plan is already mid-year, the focus shifts to confirming the data and limiting the damage.
Step 1: Recheck Testing Inputs
Before assuming the plan has failed beyond repair, employers should confirm:
Compensation data is accurate.
HCE determinations are correct.
Participant elections are complete and properly reflected.
Testing errors are more common than many employers realize.
Step 2: Apply Allowed Exclusions Correctly
There are limited exclusions that may improve results, but they must be applied properly.
For the 55% Average Benefits Test, employees earning less than $25,000 per year may be disregarded when benefits are provided through salary reduction elections. This does not always change the outcome, but in some cases it can help a plan pass or reduce the amount that must be corrected.
In addition, plans may exclude certain groups if the DCAP excludes them from participation:
Employees who have not attained age 21
Employees with less than one year of service.
Employees covered by a collective bargaining agreement, provided dependent care benefits were the subject of good faith bargaining and those employees are not included in the plan.
These exclusions must align with the plan’s eligibility terms and cannot be applied selectively after the fact.
Step 3: Reduce HCE Elections to Reach a Passing Result
If the plan still fails, the most common correction method is to reduce HCE elections.
Typically, this involves:
Calculating how far the plan exceeds the allowable threshold.
Reducing each HCE’s annual election proportionally.
While unpopular, this approach allows HCEs to retain some tax-free benefit. If no correction is made and the test fails, the affected HCE benefits must be treated as taxable income.
Planning Ahead for Future Years
The real opportunity is avoiding repeat failures.
Option 1: Increase Non-HCE Participation Through Better Education
Brokers and employers can also improve testing results by focusing on participation, not just limits.
Many DCAP failures are driven by low non-HCE enrollment, not excessive HCE elections. Improving participation among non-HCEs can materially improve testing outcomes.
Practical steps include:
Giving DCAP a more intentional “sales pitch” during new hire onboarding.
Reinforcing DCAP education during open enrollment, especially for employees with younger children.
Using simple examples that show the difference between paying for dependent care with post-tax dollars versus pre-tax dollars.
Highlighting FICA savings, which are often overlooked and resonate once explained plainly.
For employees who are less financially savvy, seeing a basic paycheck comparison can make the value of DCAP participation much clearer. Even modest increases in non-HCE elections can significantly improve the 55% Average Benefits Test result.
Option 2: Cap HCE Elections Prospectively
Even when flex vendors cannot administer different election limits, employers can:
Amend the plan document to impose an HCE-specific cap.
Communicate the rule clearly before enrollment.
Monitor elections and correct excess amounts early.
This is not seamless, but it can be effective when managed carefully.
A more drastic variation is to exclude HCEs from DCAP participation entirely. While not ideal, this approach is becoming more common for employers who consistently fail testing.
Option 3: Evaluate the Top 20% Rule
Some employers may benefit from using the “Top 20% Rule,” which allows the definition of HCEs to be limited to the top 20% of earners instead of the statutory definition.
Important considerations:
This must be adopted before the start of the plan year.
It must be applied consistently across applicable benefit plans, including retirement plans.
The retirement plan impact should be reviewed carefully before adopting this approach.
Adopting this rule to fix a DCAP problem while creating retirement plan testing issues would be a costly mistake.
A Reality Check for HCEs
DCAPs are valuable and offer FICA savings, but they are not the only tax tool available.
Employees who cannot take full advantage of a DCAP may still be eligible for the child and dependent care tax credit on their individual tax return. While not identical, this option often helps put the limitation into perspective.
Helping employers communicate this early can reduce frustration and set realistic expectations.
Broker Action Steps
Confirm whether the employer plans to allow the $7,500 maximum for 2026.
Model nondiscrimination testing results early.
Verify testing inputs and allowable exclusions.
Discuss prospective plan design changes.
Coordinate Top 20% decisions with retirement plan advisors.
Set expectations with HCEs before enrollment begins.
FAQs
What happens if a DCAP fails the 55% Average Benefits Test? Highly Compensated Employees may lose the tax exclusion on discriminatory DCAP benefits, which then must be reported as taxable wages.
Can employers fix a DCAP failure mid-year? Sometimes. Options are limited to correcting data errors, applying allowable exclusions, or reducing HCE elections.
Can HCEs be limited to a lower DCAP election amount? Yes, if the plan document is amended prospectively, even if the vendor cannot automatically enforce the limit.
Is excluding HCEs from the DCAP allowed? Yes. While not ideal, it is a compliant option and increasingly common for employers with repeated testing failures.
Can employees still claim the dependent care tax credit? Yes. Employees who do not receive DCAP benefits may still evaluate the credit on their individual tax return, subject to applicable limits and coordination rules.
References
Internal Revenue Code Section 129 – Dependent Care Assistance Programs
IRS Publication 503 – Child and Dependent Care Expenses
IRS Instructions for Form 2441 – Child and Dependent Care Expenses
IRS Instructions for Form W-2 and W-3 – Taxable Fringe Benefits and Dependent Care
IRS Proposed and Final Regulations under Section 129 (Dependent Care Assistance Programs)