Dependent Care Debate: Plan Savings or Tax Credit
August 26, 2021
Since March of 2020, the federal government has passed several relief bills due to the COVID-19 pandemic. In these bills, consideration has been given to create much-needed flexibility for employers who offer dependent care assistance programs (DCAPs). In particular, the American Rescue Plan Act of 2021 (ARPA) increased the income exclusion from $5,000 to $10,500 (and from $2,500 to $5,250 for married individuals filing separately) for the 2021 calendar year.
At the same time, the dependent care tax credit was greatly expanded allowing individuals in 2021 to receive better tax advantages by using the tax credit than contributing to their employer-sponsored dependent care accounts. This raises the question whether employers should spend effort and planning to increase the DCAP plan limits to the maximum allowable by law.
Without further action by Congress, the dependent childcare tax credit is fully refundable for the 2021 plan year only. The credit percentage has been increased from 35% to 50% but drops to 20% for individuals with adjusted growth income (AGI) between $125,000 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 increases to from $3,000 to $8,000 for one qualifying individual and from $6,000 to $16,000 for two or more qualifying individuals.
In considering whether to increase the DCAP limit for 2021, there are a number of factors for employers to consider:
- How many employees currently participate in the dependent care assistance plan?
- Would increasing the dependent care assistance contribution limit help those participants?
- Would increasing the dependent care assistance contribution limit cause the plan to fail nondiscrimination testing for the DCAP, particularly, the 55% average benefits test? (For 2021 testing, generally employees earning over $130,000 in 2020 could not make up more than 45% of the total benefits received by all participants or fail the test.)
- Are there any potential system issues related to the mid-year dependent care plan increase that might make the increase impractical?
Employers should not actually assist employees with making the determination of whether the dependent care program 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. Employers who decide to increase their dependent care program amounts will need to amend their plan by the end of the plan year in which the change is effective (e.g., December 31, 2021). As always, we recommend that all parties consult with a tax advisor to carefully review their situation.