PA Excludes Dependent Care Assistance from Taxable Income

The Commonwealth of Pennsylvania enacted 2023 Act 34, Section 202.3 (HB 1300), which brings its tax treatment of dependent care assistance provided by an employer in line with the federal income tax exclusion under section 129 of the Internal Revenue Code (IRC). Importantly, “dependent care assistance” includes employee contributions to dependent care assistance programs or, as they are also commonly known, dependent care flexible spending accounts (FSAs). This change means that up to $5,000 per year in employer-provided dependent care assistance benefits (up to $2,500 if married and filing separately) may be excluded from Pennsylvania personal income tax by employees and excluded from PA personal income tax withholding by employers. This resolves a long-standing disconnect between the federal and Commonwealth tax rules with respect to dependent care assistance. The Act is effective retroactively to January 1, 2023.

According to the Pennsylvania Department of Revenue (DOR) guidance, the types of dependent care assistance benefits now excluded from Pennsylvania income tax and withholding include:

• The fair market value of employer-provided daycare facilities;
• An amount paid directly to a daycare facility by the employer or reimbursed to the employee to subsidize the cost; and
• Pre-tax contributions made by the employee under an IRC Section 125 dependent care FSA.

Because this change was enacted very late in 2023, some employers presumably withheld amounts for Pennsylvania personal income tax on dependent care assistance throughout the 2023 tax year and may have reported those amounts as income on Forms W-2. This could cause an issue when an employee who has received a dependent care assistance benefit from an employer in 2023 files their PA Personal Income Tax Return (PA-40). To allow affected employees to claim a refund on their Pennsylvania personal income tax return (PA-40), the PA DOR guidance suggests that affected employers take the following steps:

• If the dependent care amounts were included on an employee’s Pennsylvania Form W-2, file a corrected W-2 with the appropriate amount in dependent care assistance excluded. Provide an updated W-2 to the employee to alert them of the correction.
• On the amended W-2, the amount of dependent care benefits reported in box 10 (up to applicable limits) should not be included in box 16, State Wages.
• Do not file amended W-3s and Annual Withholding Reconciliation Statements (REV-1667s) removing the withholding previously made on dependent care benefits. Only amend the W-2 compensation. Employees may report any over withholding on their PA-40 and obtain a refund, if applicable.

Employers that have continued to treat dependent care assistance as taxable in Pennsylvania in 2024 should stop withholding as soon as practically possible, and dependent care assistance should not be included in employees’ Pennsylvania personal income on 2024 W-2s.

Additionally, employers should make sure that their dependent care FSA materials are updated to remove any language that reflects the prior taxation of these contributions in Pennsylvania.

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