Benefits for Highly compensated employees moving to post tax

[JJ123]

So my company failed  Section 125 Nondiscrimination Testing and a decision was made to change all pre-tax benefits for Highly compensated employees to taxable income immediately  ending the FSA program for 2024.   Company is refunding all the contributions made to the date.  If an employee already made payout on the FSA account, are they legally required to pay back? What happens if they don’t?

[CuseFan]

If you've contributed $X YTD then I think the cash refund you'll get is $X less whatever claims have been paid to you. If your paid claims were more than $X, I don't think the excess can be clawed back (like if you terminated and your YTD claims exceeded your YTD contributions). But that is just the cash flow issue. Whatever you had contributed YTD will all be taxable to you regardless of cash refund amount and also subject to FICA and Medicare taxes.

There is a very smart health and welfare plan practitioner in this forum who hopefully will see this and either confirm my understanding or set me straight and give you the correct answers.

[Brian Gilmore]

Ha, let's hope that practitioner weighs in to set us all straight, Kenneth.

Agreed, the distributions already made will just be recharacterized as taxable income.

Here's an overview of the approaches that I've posted:

https://www.newfront.com/blog/the-dependent-care-fsa-average-benefits-test

Correcting an ABT Failure Where HCEs Have Already Exceeded the Reduced Limit

In some situations, employers will not discover an ABT failure in time to impose a reduced HCE contribution limit prior to HCEs contributing to the dependent care FSA in excess of that limit. 

For example, suppose the ABT pre-test results show that HCE elections must be reduced by 20%, resulting in HCEs who elected the $5,000 maximum having to drop to $4,000.  If those HCEs have already contributed $4,375, there is a $375 excess that must be made taxable income before the last day of the plan year.

There are two basic approaches to converting excess HCE dependent care FSA contributions to taxable income:

1. Refund/Return: The employer can distribute the excess contributions back to the HCEs through payroll as taxable income subject to withholding and payroll taxes by the end of the year, thereby reducing the amount available in the HCEs’ dependent care FSA account balance.  Note that this approach will not work for HCEs that have already received reimbursement of the excess amount.
2. Recharacterize: The employer can recharacterize the excess contributions as taxable income subject to withholding and payroll taxes without directly refunding the excess to HCEs.  The downsides of this approach are that the employer will need to a) take the withholding and payroll taxes from other income, and b) inform the HCEs that they may take a distribution of the excess contributions (which no longer have pre-tax status) from the FSA without the need to submit qualifying dependent care expenses.

With either approach, the employer will need to coordinate with the FSA TPA to ensure proper administration of the correction.  As always, the employer will need to take action before the end of the year to ensure a passing result as of the last day of the plan year.

[Belgarath]

16 hours ago, CuseFan said:

There is a very smart health and welfare plan practitioner in this forum who hopefully will see this and either confirm my understanding or set me straight and give you the correct answers.

Yeah, that guy is good!!!

[CuseFan]

I knew Brian would come to the rescue!

[Belgarath]

Yes, as they would say in Good Will Hunting, he's wicked smaht!