ARPA Temporarily Increases Dependent Care Maximum to $10,500 (or $5,250) for the 2021 Tax Year
In addition to a 100% COBRA subsidy, the American Rescue Plan Act of 2021 (“ARPA”) temporarily increases the maximum amount of Dependent Care FSA benefits that can be excluded from a participant’s income. Generally, $5,000 (or $2,500 if married filing separately) is the maximum that can be excluded from a Dependent Care FSA participant’s income. Under the ARPA, for the 2021 calendar year only the Dependent Care FSA maximum is increased from $5,000 to $10,500 (and from $2,500 to $5,250 for taxpayers who are married filing separately). Below is a discussion of some implications of this temporary increase. Contact us if you have any questions.
First, it appears the primary intent of this temporary increase is to resolve the tax issue created by the Consolidated Appropriations Act (“CAA”) relief on DCAP reimbursements in excess of the maximum limits. The CAA relief for Dependent Care FSAs created the potential for a participant with unused account balances from a plan year ending in 2020 to receive reimbursement of qualifying Dependent Care expenses in 2021 in excess of the prior $5,000/$2,500 limits. The excess reimbursement amounts would have been treated as taxable income. With the temporary increase, participants in plans that adopted the extended grace period for Dependent Care FSA can now receive reimbursement for qualifying expenses in 2021 up to the new maximum limit. This relief from taxation does not require the employer to adopt an increase to their Dependent Care FSA plan maximum.
Second, by virtue of the temporary increase, employers may (but are not required to) increase their Dependent Care FSA plan maximum for the 2021 tax year. Plans can be amended retroactively so long as the change is adopted by the last day of the plan year in which the amendment is effective. If adopted, individuals can make mid-year election changes under either (1) the CAA election change relief if adopted by the plan (without a change in status) or (2) the IRS allowable election change event of significant improvement of benefits. While this increase would be welcome on a permanent basis (the $5,000/$2,500 limits have been in place since 1986), the temporary nature of this change creates some real challenges and employers should carefully consider the impact the temporary increase may have on their plan including, but not limited to:
- Current Dependent Care FSA nondiscrimination testing rules remain unchanged meaning that the average Dependent Care benefits provided to highly compensated participants cannot exceed 55% of the average Dependent Care benefits provided to non-highly compensated participants. The 55% Average Benefits test is frequently failed by plans, thus requiring mid-year election reductions for highly compensated participants. This temporary increase has the potential to create (or exacerbate) testing failures.
- There are unique challenges for fiscal year plans. Since the increase is only applicable for the 2021 tax year, fiscal year plans will need to pay close attention to how the temporary increase works for their plans. Since contributions are generally made ratably throughout the plan year, there may be tax consequences to participants in 2022. It may be necessary for participants to reduce their contributions mid-year during the 2021-2022 plan year to ensure that contributions made during calendar year 2022 do not exceed the $5,000/$2,500 limit.
- Forfeiture remains an issue for participants. This is true even for participants in plans that have adopted the CAA relief as forfeiture for these plans comes back into play for the plan year ending in 2022. This temporary increase creates the potential for larger participant forfeitures.
- Participants taking advantage of the increased maximum who also have unused funds from the plan year ending in 2020 risk taxation of dependent care reimbursements in excess of $10,500 (or $5,250 for married filing separately) in 2021.
Even if a plan does not adopt the temporary increase, participants may be able to take advantage of temporary increases to the dependent care tax credit for 2021. The ARPA temporarily increases the dependent care tax credit from $3,000 to $8,000 for taxpayers with one qualifying individual and from $6,000 to $16,000 for taxpayers with two or more qualifying individuals. The child tax credit and earned income tax credit were also changed by the ARPA.
The information included in this post is for explanation only and is not intended as tax or legal advice. In all matters where tax or legal advice is needed, the services of professional counsel should be sought.