Lockton findings: Working families should evaluate dependent care FSAs

As employers approach open enrollment season, it’s important to note that the recently passed One Big Beautiful Bill Act raises the contribution limits employees can make to a dependent care flexible spending account (FSA) beginning Jan. 1, 2026.

This change poses an interesting question for employers and employees: which provides the greater tax advantage, a dependent care FSA or the dependent care tax credit?

The answer will vary, depending on an employee’s childcare needs, filing status and income level. However, a recent analysis by Lockton’s Actuarial Team leads us to the following recommendations as an insurance brokerage:

• That working families should carefully consider choosing a dependent care FSA instead of taking the tax credit, based on the 2026 increase in allowed FSA contributions from $5,000 to $7,500 (or from $2,500 to $3,750 if an employee is married but filing separately). Please note: our analysis doesn’t take into account every individual’s circumstances, so we strongly recommend that employees consult a tax advisor to determine which approach works best for them.

• That employers consider taking steps to adjust their dependent care FSAs to ensure they clear the 55% discrimination test, and that they clearly communicate the options that non-highly compensated employees have in choosing between the FSA or the tax credit.

What’s changing in 2026

Employees have always been able to use a dependent care FSA or the child or dependent care tax credit for their dependent care expenses, but they cannot double-dip the same expenses across both tax programs. The tax credit is claimed on an employee’s IRS Form 1040.

What’s new in January is that the pre-tax threshold for “dependent care assistances programs” (like dependent care FSAs) will increase from $5,000 to $7,500 if an employee is single or filing jointly with a spouse. For an employee who is married but filing separately, the cap will increase from $2,500 to $3,750.

For many individuals and families, having a boost to that annual exclusion limit could make a dependent care FSA more enticing than claiming the tax credit. Going into next year, while the tax credit expense limit will remain $3,000 for one dependent and $6,000 for two or more dependents, the tax credit will increase from 35% to 50% of dependent care expenses for lower-income employees. The tax credit percentage gradually decreases for individuals with higher income, but the floor remains at 20%.

The impact of these changes on employees

Using a propriety calculation tool, Lockton’s Actuarial Team examined different tax scenarios based on an employee’s adjusted gross income, whether they were filing single or jointly, and the number of children incurring dependent care expenses. The analysis did not factor in state income taxes, where applicable.

The findings led to two general observations:

• For single employees, the dependent care FSA is more advantageous than the tax credit, except for very low-wage employees (in general, those who have adjusted gross income of less than $15,000 with one dependent and less than $50,000 with two or more dependents).

• For married employees, the dependent care FSA is more advantageous than the tax credit, except for very low-wage employees (with adjusted gross incomes for married couples in general averaging double the amount of the single earners listed above).

However, because every individual’s financial situation is different, employees must work with their own tax advisors to determine which is more beneficial given their unique facts and circumstances, including state income taxes.

Implications for employers: the 55% test

Dependent care FSAs are subject to a discrimination test that compares the utilization by highly compensated employees (HCEs) and non-highly compensated employees. The test requires that the average benefits provided to non-highly compensated employees must be at least 55% of the average benefits provided to the HCEs.

Employers who conduct this 55% benefits test often must cut back the elections of HCEs for the plan prior to year-end for the plan to pass. For 2026, an HCE is any employee who earned more than $160,000 in 2025.

The One Big Beautiful Bill Act’s increase of the dependent care FSA limit may make it more difficult for employers to pass the 55% test next year, as the highly compensated tend to have the disposable income to contribute more to their FSAs than do rank-and-file employees. A best practice is to test early in the year so, if necessary, the employer has plenty of time to cut back elections of the highly compensated. The availability of the expanded tax credit in 2026 may cause some employers to re-examine offering a dependent care FSA if they fail the 55% test year after year.

FSAs or the tax credit: what should employers communicate?

Traditionally, employer open enrollment guides instruct the employee to consult their tax advisor on whether the dependent care tax credit or day care FSA is more beneficial and that holds true to 2026.

Why? Because this is considered tax advice. Moreover, employers often need lower-paid employees to participate in the day care FSA to pass the 55% test. Employers need to consider whether or not the increased contribution limits to a dependent care FSA will affect the FSA’s nondiscriminatory status. If these projections fail the 55% test, employees can consider taking the following steps:

• Adjusting the dependent care FSA to restrict elections by HCEs.

• Clearly communicating to employees any changes to the dependent care FSA and promoting the advantages of utilizing the FSA to non-highly compensated employees.

• As in prior years, employers’ open enrollment guides should continue to instruct employees to consult their tax advisor on whether the dependent care tax credit or FSA is more beneficial for them.

For more information on measuring the benefits of the dependent care FSA versus the tax credit, we encourage you to reach out to your Lockton account team. For additional perspective on compliance changes from the One Big Beautiful Bill Act, read our July 2025 alert (opens a new window).