Compliance News | March 17, 2021
The American Rescue Plan Act (the Act), which President Biden signed into law on March 12, 2021, significantly expands federal assistance to families with children. For 2021, that includes increasing the Child and Dependent Care Tax Credit (CDCTC) and the amount of dependent care assistance program (DCAP) benefits that a participant can exclude from taxable income.
Employers that sponsor DCAPs should carefully review these changes and be aware of potential implications for nondiscrimination testing.
This post now reflects additional IRS guidance on DCAPs.
The CDCTC and the tax exclusion for employer-sponsored DCAPs are related, but distinct, Internal Revenue Code provisions concerning childcare expenses for qualifying individuals. Qualifying individuals include a taxpayer’s dependents who are under age 13 when the care is provided, or a spouse or other dependent who is not physically or mentally able to care for themself.
A taxpayer must subtract from the maximum applicable CDCTC any benefits excluded from income through a DCAP. Accordingly, individuals with qualifying childcare expenses whose employers sponsor a DCAP can determine annually whether the DCAP exclusion or claiming the full CDCTC is more advantageous to them from a tax perspective. The determination should take into account their adjusted gross income (AGI) and childcare expenses.
Prior to the Act, the CDCTC provided a non-refundable credit of as much as 35 percent for qualifying childcare expenses up to $3,000 for households with one child and up to $6,000 for households with two or more children. The credit phased out for incomes above $15,000. The maximum permitted contribution for DCAPs was $5,000 ($2,500 if married and filing separately).
For 2021, the Act:
|Prior to the Act||Under the Act|
|Credit for qualifying childcare expenses||As much as 35%||As much as 50%|
|Households with one child||$3,000||$8,000|
|Households with two+ children||$6,000||$16,000|
|Phase-down to 20% begins for incomes above||$15,000 of AGI||$125,000 of AGI|
|Complete phase-out begins for incomes above||N/A||$400,000|
|DCAP maximum contribution||
$5,000$2,500 if married and filing separately
$10,500$5,250 if married and filing separately
Because of these changes, some employees who previously would have been better off from a tax perspective contributing to a DCAP may find themselves in a more favorable tax position by claiming the full CDCTC in 2021 or vice versa. For example, an individual with AGI of $125,000 in 2021 may save more in taxes via CDCTC given the CDCTC percentage change to 50 (which is higher than their tax bracket plus FICA tax) from 20 percent (which is lower than their tax bracket plus FICA tax). Because the question of whether using a DCAP or claiming the CDCTC is more advantageous presents a different answer based on each employee’s particular set of facts, employees should consult their tax advisors to help determine which option to choose.
Under the Consolidated Appropriations Act of 2021 (CAA) and subsequent IRS guidance, plan sponsors are permitted (but not required) to let employees make mid-year changes to their DCAP contributions for plan years ending in 2020 or 2021, even without an event, such as the birth of a child, or a significant change in childcare costs. (See our March 5, 2021 compliance insight.) To the extent that employees take advantage of this flexibility to change their 2021 DCAP contributions in reaction to the Act, there could be adverse effects on an employer’s DCAP nondiscrimination testing.
On another positive note, the IRS has provided relief for plan sponsors that added a carryover or extended the grace period under the provisions of the Consolidated Appropriations Act of 2021. Under those provisions, employers sponsoring DCAPs are permitted to provide for an unlimited carryover from plan years ending in 2020 and 2021 to the plan years ending in 2021 and 2022, respectively. Similarly, for plans with a grace period, for the plan years ending in 2020 and 2021, the plan sponsor can elect to extend the grace period to as late as the end of the plan year ending in 2021 or 2022, respectively.
In May 10, 2021, the IRS granted relief in Notice 2021-26 by clarifying that DCAP benefits that would have been excluded from income if used during the taxable year ending in 2020 or 2021, as applicable, remain eligible for exclusion from the participant’s gross income. Additionally, they are disregarded for purposes of application of the limits for the subsequent taxable years of the employee when they are carried over from a plan year ending in 2020 or 2021 or permitted to be used pursuant to an extended claims period.
Can an employer that is concerned about the potential for adverse DCAP testing continue to limit employees to DCAP contributions of $5,000 ($2,500 if married and filing separately), notwithstanding the Act? There is no clear answer to this question.
On the one hand, the CAA and subsequent IRS guidance permit but do not require employers to allow for more flexibility in cafeteria plan benefits, including mid-year changes to their DCAP contributions. If an employer has not adopted the increased flexibility, an employee would ordinarily not be able to make a mid-year election change in light of the Act. Moreover, employers can generally impose a plan limit that is below the maximum statutory limit on the amount their employees can contribute to a DCAP — and many do so for highly compensated employees in order to comply with nondiscrimination requirements.
On the other hand, an employee who has a mid-year change in election due to a qualifying event, like the birth of a child, could change, under most plans, their election mid-year even if the employer does not adopt the increased flexibility provisions. Additionally, if the plan document refers to the annual Internal Revenue Code limit on DCAP deferrals as the default, it is possible that an employer would have to amend the plan in order for the Act’s increase not to apply.
Presumably, future regulatory guidance will address these issues.
Employers should work with their legal counsel in considering whether to allow mid-year election changes to DCAPs in light of the Act as well as any plan amendments that may be necessary.
Plan sponsors that allow the changes should closely monitor for an adverse effect on 2021 DCAP nondiscrimination testing — and take steps to limit contributions for highly compensated employees, as needed.
Plan sponsors may also wish to think about communicating with employees to help them understand these changes.
Ultimately, the decision whether to contribute to DCAP exclusion or claim the full CDCTC is a personal tax matter that employees should discuss with their tax advisors.
This page is for informational purposes only and does not constitute legal, tax or investment advice. You are encouraged to discuss the issues raised here with your legal, tax and other advisors before determining how the issues apply to your specific situations.
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