Plan fails DCAP testing. Is it really that big a deal?

Let me explain what I mean by that, not being a Cafeteria plan guru. As I understand it, if testing is failed, then the NHC's have no consequences - their benefits are still excluded from income. The HCE's will have their benefits included in income. So isn't this just the same position they would be in anyway? They (the HCE's) are no WORSE off than they would be otherwise without the plan - what's the real downside?

I feel like I'm maybe missing something - I'd be interested in any thoughts you may have. Thanks!

In many aspects of life, logic does not always persuade.

Consider that highly-compensated employees often includes people who decide, directly or practically, whether to retain an employee-benefits service provider.

Here’s a Brian Gilmore webpage that explains the measure, and suggests what to do. https://www.newfront.com/blog/the-dependent-care-fsa-average-benefits-test
 

Thanks Peter. And yes, anything from Brian is always superlative information!!

Haha, thanks guys.  Belgarath, you're making a glass half full pitch here.  I agree.  The glass half empty side is the HCEs lose a portion of the tax-advantaged benefit that they expected.  Some of that can be made up for usually with the dependent care tax credit, but it's really about managing expectations.

Many employers go overboard and cap HCE contributions from the outset at some arbitrary number in the desperate attempt to try to avoid giving HCEs bad news or to avoid minor payroll tweaks.  I'm not a fan of that approach.  In my mind you aim for the full $5k and work downward from there (based on the pre-test results) to get every last pre-tax dollar you can for the HCEs.  The communications challenge is convincing those HCEs they're better off reducing downward from $5k than they would have otherwise been by capping them from the outset at a lower number than the test results might have required.

Here's the good, the bad, and the ugly of strategies I've seen out there in the world to try to address the issue--

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

Strategies to Avoid ABT Failures: The Good, the Bad, and the Ugly

Employers clearly become frustrated with failing the ABT year after year, and in many cases they overcompensate with approaches that unnecessarily harm HCEs.  The following are a few of those strategies:

The Good: Offer an Employer Matching Contribution to Non-HCEs

The only approach to reducing the risk of testing failure that is recommended is to incentivize NHCEs to participate in greater numbers and to a greater degree.  Although it is uncommon because of the increased employer cost, a few employers have taken the smart approach of offering NHCEs additional employer contributions as a carrot to encourage greater participation.

One particularly effective approach is to offer an employer matching contribution to the dependent care FSA for NHCEs that operates in a similar manner as a 401(k) plan matching contribution.  For example, the employer might offer a dollar-for-dollar matching contribution for NHCEs of up to $500.  This will entice greater participation and higher elections from NHCEs, which will in turn significantly improve the employer’s chances of passing the ABT.

The Bad: Limit HCE Contributions to a Reduced Level from the Outset

A common approach that is not recommended is for employers to simply cap HCE elections from the beginning at a reduced level.  For example, HCEs may elect only up to $3,000 instead of the standard $5,000 limit available to NHCEs.

Although this approach does improve the chances of passing the ABT because it will decrease HCE dependent care FSA benefits by design, it does so in a very haphazard manner.  In that example, allowing HCEs full elections and pre-testing may have resulted in a required reduction of $5,000 HCE elections to $4,000 to reach a passing 55% level.  However, by capping HCE elections at $3,000, the employer would have effectively preemptively precluded HCEs from enjoying an additional $1,000 pre-tax contribution.

This approach is therefore not recommended because it will always either a) cause HCEs not to be able to take advantage of the maximum permitted pre-tax election, or b) require only a slightly smaller correction to HCE contributions than would have otherwise been required if they initially could have elected up to the full $5,000 maximum.

The Ugly: Permit Only NHCEs to Participate in the Dependent Care FSA

This approach has the advantage of guaranteeing the plan will pass the ABT because 100% of the benefits will be for NHCEs.  However, needless to say this approach does not go over well with the HCEs who are blocked entirely from dependent care FSA participation.

Best Practice Approach

Employers should not preemptively cap HCE elections at the outset, but instead run an early pre-test (e.g., summer for a calendar plan year) to determine any reduced contribution limit required to pass the ABT.  This approach ensures that HCEs receive the maximum pre-tax benefit that can be made available.

Although it is common for employers not to pass the ABT in pre-test results, running the test early will typically catch the issue before HCEs have contributed up to the reduced limit needed to achieve 55%.  The administrative burden is relatively minor where the adjustment simply requires a payroll contribution cap for HCEs.

Slide summary:

2025 Newfront Section 125 Cafeteria Plans Guide

Hi Brian - thanks so much for the information. One more question, if I may - suppose an employer wants to implement a plan this year - say, with a March 1 effective date. The regulations permit a short plan year for a "valid business purpose." It would seem that having a short plan year for the first year, to enable subsequent years to be calendar years would qualify? And then the $5,000 limit would be easy to calculate each year without "overlap" problems, and it wouldn't have to be pro-rated for the short 2025 plan year? Thanks!!

Yes, I agree.  I think that's perfectly fine and a normal approach.  Plus, as you noted, it's definitely way better to have a calendar plan year dependent care FSA going forward to avoid multiple issues.  Normally I would recommend a prorated limit on a short plan year to avoid complications, but if it's a brand new plan I agree that's a non-issue.

• More details: https://www.newfront.com/blog/dependent-care-fsa-limit-challenges

Thanks!!!