One intention of The American Rescue Plan Act (ARPA) is to provide financial support for families struggling due to the pandemic, such as the temporary COBRA subsidies to help employees maintain health insurance.
The Act also includes some provisions that may be beneficial for employees with children to help afford the cost of childcare during this crisis. If a business allows employees to pay for childcare with pre-tax dollars through a dependent care assistance program (DCAP), then for 2021, the ARPA gives employers the ability to raise the DCAP flexible limit to $10,500. This is a very significant increase from the standard $5,000 ($2,500 for married individuals) annual DCAP flexible spending limit. Since the standard DCAP limit is not adjusted annually for inflation, if an employer allows the one-time change, it could be very popular with employees whose actual childcare costs far exceed the standard limit.
ARPA DCAP Provisions and the CAA and IRS Notice 2021-15
By allowing a change in the DCAP limit for the 2021 calendar year, the ARPA helps clarify some pre-existing tax ambiguity related to DCAPs. Part of a previous COVID-19 economic stimulus law, the Consolidated Appropriations Act of 2021 (CAA), allowed special temporary rules for DCAPs. As clarified in IRS Notice 2021-15, the CAA permits flexibility for the carryover of unused benefits or contributions in a DCAP from the 2020 and 2021 plan years. Typically, account funds that are not spent by the employee within the plan year, subject to limited grace periods or certain carryover amounts, are forfeited. However, for just these two years, employers, at their discretion, are able to amend their plans and let employees apply all or part of the unused DCAP amounts to pay for or reimburse dependent care expenses in the subsequent plan year.
This provision left some to wonder whether an employee who had reimbursements above the standard $5,000 ($2,500 for married individuals) annual DCAP flexible spending limit would be taxed on the excess. However, ARPA removes any uncertainty on the taxation, allowing employers to increase the DCAP limit from $5,000 to $10,500 (from $2,500 to $5,250 for married filing single) for taxable years beginning in 2021. Absent additional congressional action, the increased amount automatically expires at the end of 2021. Notice 2021-15 is also relevant when it comes to employees increasing their 2021 contributions. In addition to the flexibility to carry over unused benefits from the 2020 and 2021 plan years, employers may (but are not April 22, 2021 required to) amend their DCAP to allow employees to prospectively enroll in, increase, decrease, or revoke their DCAP elections midyear, regardless of whether they experienced a permitted change in status event.
Although not entirely clear (additional IRS guidance would be welcome), it appears if an employer with a
carryover provision amends their plan to increase the DCAP limit to $10,500 and they also adopt the flexibility to carry over the full amount of unused benefits (e.g., up to $5,000), an employee could potentially have $15,500 to use towards dependent care costs in 2021.
Similarly, the same may be true for an employer with a grace period provision who amends their plan to
extend the permissible period for incurring reimbursable DCAP expenses to 12 months, rather than the usual 2½ months maximum. An employee may have $5,000 of funds to use from 2020 and elect an additional $10,500 in 2021 for a total of $15,500.
DCAP Limit Increase and Non-Calendar Year Plans
Another area where additional action and guidance from Congress and the IRS would be welcome, concerns non-calendar year plans. The ARPA temporarily increases the standard DCAP contribution limit but appears to only be for calendar year 2021. Therefore, absent any additional congressional action, the DCAP FSA limit should revert to $5,000 for the 2022 calendar year, creating issues for non-calendar year plans.
This means that sponsors of non-calendar year plans will need to be very careful in implementing the increase.
Specifically, in implementing the change, non-calendar year plan sponsors must make sure that total
contributions in 2022 don’t exceed $5,000. Here is an illustration of how this might work:
- Employer has a 11/1 – 10/30 DCAP plan year.
- Employee originally elected $5,000 for the current year running 11/1/2020 – 10/30/2021.
- Assuming the employer pays twice a month, this means the employee contributes $208.33 per
payroll. - To ensure the employee doesn’t end up contributing more than $5,000 in 2022, the employer
resets the annual limit for the 11/1/2021—10/30/2022 plan year. - The employer elects to increase the limit under ARPA effective 5/1/2021.
- This means that the applicable annual limit for the period from January – April 2021 and
November – December 2021 is $5,000 ($208.33/payroll). - This means that for these payroll periods, the employee would be permitted to contribute $2,500
($208.33/payroll). - As a result, the maximum contribution for the period from 5/1/2021 – 10/31/2021 would be
$8,000 ($10,500 minus $2,500) or $666.67/pay period.
This, of course, becomes even more complicated if payroll is run on a weekly or bi-weekly basis. The
complexity of this analysis coupled with its temporal nature is a reason many employers with non-calendar year plans will elect not to offer the temporary annual limit increase.
DCAP Limit Increase and the ARPA’s Expansion of the Child and Dependent Care Tax Credit
Allowing the one-time increase to the DCAP limit is not the only way that ARPA attempts to help families with childcare expenses during the pandemic. ARPA also expands the Child and Dependent Care Tax Credit (CDCTC) for 2021 by making it larger and refundable. The CDCTC is an alternative federal tax break to help parents offset childcare costs. Unlike the DCAP, it is available to all tax filers with dependent children under age 13 with childcare expenses. However, qualified parents can only pick one tax break or the other. A taxpayer may not participate in a DCAP and claim the tax credit for the same dependent care expenses in the same tax year.
Prior to ARPA, the CDCTC was calculated by multiplying the amount of qualifying expenses—a maximum of $3,000 if the taxpayer has one qualifying individual, and up to $6,000 if the taxpayer has two or more qualifying individuals—by the appropriate credit rate. ARPA increased the maximum credit rate from 35% to 50%, changed the income levels allowed for the credit rates, and increased the maximum amount of qualifying expenses from $3,000 to $8,000 and $6,000 to $16,000 respectively.
The changes to the CDCTC may make it more complicated for employees to decide if they should participate in a DCAP in 2021, particularly if the employer elects to raise the DCAP limit to $10,500. The chart below outlines the differences.
PRIOR to ARPA UNDER ARPA FOR 2021
DCAP: Maximum election amount $5,000 ($2,500 if married
and filing separately)
$10,500 ($5,250 if married
and filing separately)*
CDCTC: Maximum credit rate 35% 50%
CDCTC: Maximum expenses: one child $3,000 $8,000
CDCTC: Maximum expenses: two+ children $6,000 $16,000
CDCTC: Refundable & able to exceed a
taxpayers income tax liability
No Yes
CDCTC: Maximum income allowed before
credit phases out N/A $400,000
CDCTC: Refundable & able to exceed a
taxpayers income tax liability No Yes
*Optional – if an employer amends their DCAP to allow for the change.
Employers should urge employees with questions to speak with their tax professional if they need assistance understanding whether they would benefit more from a tax perspective by claiming the increased CDCTC provided under ARPA or by increasing their DCAP election.
DCAP Limit Changes and Non-Discrimination Testing
Neither the CAA nor ARPA have changed the nondiscrimination rules for DCAPs. In general, the amounts with respect to grace periods or carryovers are excluded for nondiscrimination testing (NDT) purposes. However, if an employer allows employees to elect up to $10,500 in 2021, these dollar amounts may be included in NDT.
To pass NDT, employers must ensure that no more than 55% of all dollars in the DCAP benefit highly
compensated employees. Employers who ordinarily have trouble passing NDT may have even more difficulty if they amend their plan to allow the new $10,500 limit. So, employers will want to carefully consider and monitor the impact doubling the election limit might have on their plans and possibly impose a limit less than the maximum allowed, especially for their highly compensated employees.
Other Administrative Considerations with a DCAP Change
The decision for an employer to adopt a change to their cafeteria plan to raise the DCAP contribution limit for 2021 is optional. Businesses may do so retroactively as long as they amend their plan by the end of the 2021 plan year, and the plan operates consistently with the amendment for the full retroactive period. However, if an employer is interested in providing this increased benefit to their employees, time is of the essence. Group plan sponsors need to consider how they will begin notifying employees, allowing them to increase their election and providing ample time for the increased payroll deduction to be spread over as many pay periods as possible. Since the DCAP is not subject to the uniform coverage rule (i.e., an employee may only be reimbursed for the amount contributed ratably on a salary reduction basis and in their account), an employer will want to provide sufficient time for an employee to take advantage of the newly available limit.