The American Rescue Plan Act (ARPA), signed into law on March 11, raises pretax contribution limits for dependent care flexible spending accounts (DC-FSAs) for calendar year 2021. It also increases the value of the dependent care tax credit for 2021.
The new DC-FSA annual limits for pretax contributions increases to $10,500 (up from $5,000) for single taxpayers and married couples filing jointly, and to $5,250 (up from $2,500) for married individuals filing separately. The higher limits apply to the plan year beginning after Dec. 31, 2020 and before Jan. 1, 2022.
The contribution limit for health care FSAs remained unchanged at $2,750.
In response to the pandemic, the Society for Human Resource Management (SHRM) "worked with Congress to ensure maximum flexibility for dependent care FSAs," said Chatrane Birbal, vice president of public policy at SHRM. "Providing this flexibility is warranted for employees since many child care services were suspended over the past year, leaving dependent care funds unused," she pointed out.
Reviewing the Basics: Dependent Care FSAs and Tax Credits
A dependent care FSA—also referred to as an Internal Revenue Code Section 129 dependent care assistance program(DCAP)—is a pretax benefit account used to pay for services such as day care, preschool, summer camps and before- or after-school programs. Funds may be used for expenses relating to children who are under the age of 13 or incapable of self-care and who live with the FSA holder more than half the year.
Elder care may be eligible for reimbursement with a dependent care FSA if the adult lives with the FSA holder at least eight hours of the day and is claimed as a dependent on the FSA holder's federal tax return.
Employers can also choose to contribute to employees' dependent care FSAs. However, the combined employer and employee contributions to a dependent care FSA cannot exceed the IRS limits.
[SHRM member-only HR Q&A: What is a dependent care assistance plan (DCAP)?]
Congress and the IRS have provided other DC-FSA relief this year to help meet caregivers' needs during the pandemic, and employers should consider these changes as well as the new contribution limits when adjusting plans they sponsor. For instance:
- The Consolidated Appropriations Act, 2021 (CAA), signed into law at the end of 2020, allows employers that sponsor health or dependent care FSAs to permit participants to roll over all unused amounts in these accounts from 2020 to 2021 and from 2021 to 2022.
- IRS Notice 2021-15, issued Feb. 15, clarifies that employers may extend the dependent care FSA claims period for a dependent who "ages out" by turning 13 years old during the COVID-19 public health emergency. The limiting age remains at 14 for the 2021 plan year, but this relief only applies to dependent care FSA funds that remained unspent at the end of the 2020 plan year.
Factors to Consider
Employers that offer DC-FSAs "have a number of decisions to make as a result of this new legislation, as well as the recent guidance issued by the IRS," said William Sweetnam, legislative and technical director at the Employers Council on Flexible Compensation (ECFC), which represents sponsors of account-based benefit plans.
"Employers should consider whether they would like to offer employees a new opportunity to make or change a salary-reduction election toward their dependent care assistance FSA now that the amount has been increased," he advised. "Communications to employees will be important," he added, and employers should highlight the added value of contributing to a DC-FSA this year.
Employers should "act quickly if they want to provide the 2021 increased benefit limit to participants by making employees aware of the increased limit and providing them with enough time" to increase their contributions, said Alex Mattingly, an attorney at law firm Graydon in Cincinnati.
Participants, he added, "will have to prepare for the reduction in their paychecks each period and will want to spread the contributions over as many pay periods as possible."
Edward Leeds, employee benefits and executive compensation counsel at law firm Ballard Spahr, advised employers that sponsor DC-FSA plans "to make sure that their systems and processes allow for the higher reimbursement of dependent care expenses and that those reimbursements will not be reported as subject to federal—and, in most cases, state—income tax."
In addition, "employers should make sure that their plan documents do not include any conflicting provision," he recommended. "They should make an appropriate amendment if they do."
Leeds expects that many employers will not increase the amount that employees may contribute in 2021 to DC-FSAs but will let employees carry over all unused amounts from 2020 into 2021, as permitted by the CAA, and offer employees a 12-month grace period in 2021 to spend unused 2020 contributions, "treating those unused amounts, in addition to contributions made in 2021, as tax-free."
The DC-FSA limit increase "appears to apply only to the 2021 calendar year," wrote Brian Gilmore, lead benefits counsel at ABD Insurance and Financial Services, a benefit brokerage firm based in San Mateo, Calif. "In other words, regardless of the cafeteria plan year, the $10,500 limit is available only for calendar year 2021."
However, he added, because of the CAA election-change relief provisions, "employers should be able to permit employees to change their dependent care FSA election to coordinate with the different 2021 calendar-year limit."
Gary Kushner, president and CEO of HR and benefits consulting firm Kushner & Company in Portage, Mich., advised employers that choose to adopt the temporarily increased DC-FSA limits for 2021 to take these actions:
- Ensure the payroll system or payroll vendor can accommodate a DC-FSA limit higher than $5,000.
- Using IRS regulations in effect for 2021 under the FSA funding relief provisions of the Consolidated Appropriations Act, 2021, amend the plan document to include the midyear election changes for FSAs so that employees can elect the higher DC-FSA limits. This plan amendment must be completed by Dec. 31, 2021, even if the temporary higher limits are implemented earlier in the year.
- Communicate to eligible employees that they may make midyear DC-FSA election changes and provide forms for them to do so.
Changes to the Dependent Care Tax Credit
DC-FSA participants cannot claim the Internal Revenue Code's child and dependent care tax credit for expenses paid through a dependent care FSA, as "double dipping" is not permitted.
For caregivers who prefer to take advantage of the tax credit, the ARPA "significantly increases the value of the dependent care tax credit for 2021," explained Geoff Manville and Dorian Z. Smith, partners at HR consultancy Mercer. "The credit is fully refundable, and the maximum credit percentage increases to 50 percent (from 35 percent)," they wrote.
The credit percentage gradually phases down to 20 percent for individuals with incomes between $125,000 and $400,000, and further phases down by 1 percentage point for each $2,000 (or fraction thereof) by which an individual's adjusted gross income exceeds $400,000, Manville and Smith pointed out.
They added, "The amount of expenses eligible for the credit increases to $8,000 (from $3,000) for one qualifying individual and $16,000 (from $6,000) for two or more qualifying individuals (so the maximum credits would be $4,000 and $8,000)."
According to HR and benefits consultancy Segal, "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 [child and dependent care tax credit] in 2021 or vice versa."
According to the ECFC's Sweetnam, "the next step for congressional advocates of increased government support for families is to make this one-year increase in the dependent care assistance plans permanent as well as making permanent other family-friendly provisions, such as the child care tax credit."
He added, "Congress may be addressing these and other issues in future tax legislation."
Related SHRM Resource:
Summary: American Rescue Plan Act, SHRM Government Affairs, March 2021
Related SHRM Articles:
IRS Clarifies Relief for FSA Carryovers, SHRM Online, March 2021
Top Considerations for Adopting FSA Funding Relief, SHRM Online, January 2021
Appropriations Act Permits Midyear FSA Elections, Unlimited Carryover Amounts Through 2021, SHRM Online, January 2021
2021 FSA Contribution Cap Stays at $2,750, Other Limits Tick Up, SHRM Online, October 2020