The American Rescue Plan Act (ARPA) increases the income exclusion for employer-provided dependent care assistance programs (DCAPs) — for example, employee pretax contributions to dependent care FSAs — from $5,000 to $10,500 (and from $2,500 to $5,250 for a married individual filing a separate return) for the 2021 calendar year. Similarly, ARPA significantly expands the dependent care tax credit (which is refundable) for 2021. As a result of these changes, many employees in 2021 may receive better tax advantages by using the dependent care tax credit rather than contributing to their dependent care FSA. This begs the question, if many employees will be better off with the dependent care tax credit, should employers expend the time and effort to increase the dependent care FSA maximum?
For 2021 only (unless extended by Congress), the dependent care tax credit is fully refundable and the maximum credit percentage increases to 50% (from 35%). The credit percentage gradually phases down to 20% for individuals with adjusted gross income (AGI) between $125,000 (currently $15,000) and $183,000, and completely phases out for individuals with AGI in excess of $438,000. The amount of dependent care expenses eligible for the credit increase to $8,000 (from $3,000) for one qualifying individual and $16,000 (from $6,000) for two or more qualifying individuals (such that the maximum credits are worth $4,000 and $8,000).
In considering whether to increase the dependent care FSA limit for 2021 only, there are a number of factors that employers should consider:
- How many employees participate in the dependent care FSA and would increasing the dependent care FSA limit help those employees? According to Mercer’s 2020 National Survey of Employer Sponsored Health Plans, only 5% of eligible employees participate in a dependent care FSA and the average contribution is $3,612.
- Would increasing the dependent care FSA limit cause the plan to fail nondiscrimination testing for the dependent care FSA (particularly, the 55% average benefits test)? That test requires that the average benefits provided to non-Highly Compensated Employees must be at least 55% of the average benefits provided to High Compensated Employees (HCEs) (e.g. for 2021 testing, generally, employees earning over $130,000 in 2020) under all dependent care assistance programs of the employer. If the plan fails the 55% average benefits test, then all benefits actually paid to or received by HCEs are taxable to those employees.
- Are there any potential system issues related to the mid-year dependent care FSA increase that might make the increase impractical?
Employers that decide to increase their dependent care FSA amounts will need to amend their plan by the end of the plan year in which the change is effective (e.g., Dec. 31, 2021). Employers should not actually assist employees with making the determination of whether the dependent care FSA or dependent care tax credit is a better option, but employers should include some type of communication that informs employees of their expanded options for 2021. And as always, recommend that employees consult with a tax advisor or carefully review their situation.