Understanding Health FSAs and Dependent Care Assistance Programs
- Tom Seltz
- 21 hours ago
- 6 min read
Flexible Spending Arrangements (FSAs) and Dependent Care Assistance Programs (DCAPs) help employees save money on health and dependent care costs, respectively, using pre-tax dollars. For employers, they deliver strong tax advantages and support a more competitive benefits package. To stay compliant and ensure maximum value, it is important to understand Health FSAs and DCAPs, their eligibility rules, and annual IRS updates that affect contributions and reimbursements.
What Is a Health FSA?
A Health Flexible Spending Arrangement (Health FSA) allows employees to use pre-tax dollars towards unreimbursed, eligible medical expenses. These may include ordinary medical and pharmacy costs like copayments, coinsurance, prescription drugs, certain over-the-counter items, and approved dental or vision expenses. Health FSAs reduce taxable income for employees and lower payroll taxes for employers. Many organizations offer this benefit to support affordability and employee well-being.
Why Employers Offer Health FSAs
Employers often include a health FSA as part of their overall benefit strategy because it can reduce payroll taxes, help attract and retain employees, and improve satisfaction by lowering the cost of routine care. To remain compliant, however, Health FSAs must only be offered to those who are also eligible to elect the employer’s ACA-compliant major medical plan. Employees can waive one or the other, but must be eligible for both to retain the Health FSA’s status as an Excepted Benefit.
Employee Contribution Limits Change Annually
The IRS updates employee contribution limits every year. For example…
For FSA plan years beginning in 2024, employees may contribute up to $3,200.
For FSA plan years beginning in 2025, employees may contribute up to $3,300.
For FSA plan years beginning in 2026, employees may contribute up to $3,400.
Employers should stay informed of these updates and ensure open enrollment materials and payroll systems reflect current limits.
In addition to the amounts listed above, employers are permitted to match or contribute funds up to certain limits each year. To remain compliant, any employer contributions cannot to exceed the greater of twice the employee’s salary reduction (e.g., for an employer match) or up to $500 (e.g., for a flat dollar amount employer contribution). That said, most employers fund Health FSAs entirely with employee contributions. In those cases, the only expense to the employer is to cover administrative expenses and to fund any plan losses, such as when an employee departs midyear after reimbursing more funds than they contributed. The tax savings to the employer often offset any such expenses, often making it a budget-neutral benefit offering.
The Use-It-or-Lose-It Rule
Health FSAs must follow the regulatory requirement that unused funds do not carry over indefinitely. It is also a violation of the HIPAA nondiscrimination rules to return an employee’s unused funds back to the employee. Together, this is sometimes known as the “use-it-or-lose-it” rule.
The good news is that employers may design their Health FSA to allow a carryover into the following plan year, or else can offer a grace period of up to 2.5 months to spend the remaining funds. They cannot offer both. The IRS updates the maximum allowed carryover each year.
For example…
For FSA plan years beginning in 2024, employers may allow up to a $640 carryover into the next plan year.
For FSA plan years beginning in 2025, employers may allow up to a $660 carryover into the next plan year.
For FSA plan years beginning in 2026, employers may allow up to a $680 carryover into the next plan year.
Because the allowed amount changes each year, clear communication should be used to prevent forfeiture and reduce employee confusion.
Administrative Requirements and Compliance
FSAs require active oversight to ensure proper claims processing, timely reimbursements, and compliance with IRS rules. This includes documentation requirements and annual nondiscrimination testing to verify that plans do not favor highly compensated employees.
Many employers work with a third-party administrator to help manage paperwork and testing, but the employer remains responsible for compliance.
Because Health FSAs are technically a type of supplemental self-funded health plan, they are also subject to COBRA, HIPAA, the Affordable Care Act, and other laws regulating health plans. Among other things, this means that when coverage under a Health FSA is lost due to a COBRA Qualifying Event, the employer must determine if the account is ‘underspent’, in which case a COBRA Election Notice is required.
First dollar Health FSAs are not HSA-compatible, so those also offering a High Deductible Health Plan (HDHP) may wish to also offer a Limited Purpose or Post-deductible FSA that does not revoke an individual’s status as an HSA Eligible Individual.
Staying Current with FSA Compliance
FSA rules related to eligibility, reimbursement standards, and contribution limits change periodically through federal updates. Employers should review these changes each year and confirm that plan documents, open enrollment communications, payroll systems, and TPA coordination reflect the latest requirements. Proactive monitoring helps avoid costly compliance issues. Employers should also strongly consider utilizing a vendor to administer their FSA’s COBRA obligations.
What Is a Dependent Care Assistance Program (DCAP)?
A Dependent Care Assistance Program (DCAP), sometimes marketed as a Dependent Care FSA or “DCFSA”, is another account-based plan that allows employees to set aside pre-tax income to pay for eligible daycare expenses. The maximum DCAP election is $7,500 per tax household (or $3,750 for married filing separately) per tax year, up from the previous maximum of $5,000 (or $2,500 for married filing separately).
These expenses enable the employee and their spouse, if married, to work or actively look for work. Eligible employment-related expenses can include:
Childcare for children under age 13
Before and after-school care
Summer day camps
Care for a spouse or dependent who cannot care for themselves
DCAPs fall under Internal Revenue Code Section 129 and must follow strict federal rules for eligibility, nondiscrimination testing, and reimbursement. Because DCAPs are not health plans, however, they are not subject to COBRA, HIPAA, the Affordable Care Act, and other laws regulating health plans.
Both Spouses Must Be Gainfully Employed
For married employees, both spouses must be working or actively seeking work on the days they claim dependent care expenses. A stay-at-home spouse means the expense is not considered employment-related, so it cannot be reimbursed from the DCAP.
Example:If an employee elects dependent care funds early in the year but later decides not to return to work after a new baby arrives, any unused funds may be forfeited.
Employees May Enroll Before a Child Is Born
Although birth, adoption, or placement for adoption will trigger a HIPAA Special Enrollment Right allowing a new parent to elect the DCAP, enrollment does not require an existing qualifying dependent. Therefore, an expectant parent can elect a DCAP during open enrollment to prepare for future childcare needs. However, reimbursements cannot be accessed until after the child is born, adopted, or placed for adoption and work resumes. This timing rule underscores the importance of election planning and communicating expectations with HR.
Who Qualifies as a “Qualifying Individual”?
A DCAP may only reimburse expenses for:
A dependent child under age 13
A dependent or spouse incapable of self-care
These rules help prevent ineligible reimbursements and ensure compliance with Section 129.
The Use-It-or-Lose-It Rule for DCAPs
Like Health FSAs, DCAPs have a use-it-or-lose-it rule, where unused funds are forfeited after the deadline for eligible care expenses. DCAPs are permitted to have up to a 2.5-month grace period; however, there is no carryover feature available to DCAPs.
“The information in this article is provided for general educational purposes and reflects our understanding of applicable laws and regulations as of the publication date. Benefits-related requirements change frequently, and individual circumstances can vary. Before acting on any of the guidance herein, please consult with Benefits Compliance Solutions to confirm that you have the most current and applicable information for your situation.”
FAQs
What is the difference between a Health FSA and a DCAP?
A Health FSA reimburses eligible medical expenses. Like other types of health plans, a participant has access to the full benefit elected on day one, and if the employee terminates employment and leaves with an ‘overspent’ account, the employer is not permitted to collect the plan’s losses from that individual. A DCAP covers childcare or dependent care that allows the employee and spouse to work. It is not a health plan, so unlike a Health FSA, the DCAP is pay-as-you-go, meaning that the employee only has access to the funds collected year-to-date through payroll deductions. It therefore should be impossible to ‘overspend’ a DCAP.
Can an employee elect DCAP funds before a baby is born?
Yes. They can elect ahead of time, but reimbursements can only occur after the child is born and both spouses are working.
What happens to unused funds?
Health FSAs follow the use-it-or-lose-it rule, where unused funds may be forfeited unless an employer offers a carryover or grace period. If coverage is lost due to a COBRA Qualifying Event and the Health FSA is ‘underspent’, COBRA must be offered. DCAPs also follow the use-it-or-lose-it rule if not used for eligible expenses; however, because DCAPs are not health plans, COBRA does not apply.
Do employers have to contribute to FSAs or DCAPs?
No. Employer contributions are optional, up to certain maximums. Employees can fund the accounts entirely if the employer chooses.
Who qualifies for dependent care reimbursement?
A dependent child under 13, or a spouse or dependent incapable of self-care, when care enables the employee and spouse to be gainfully employed.