The Internal Revenue Service (IRS) released Notice 2021-26 clarifying what amounts may be reimbursed under a dependent care assistance program (DCAP) on a tax-favored basis in 2021 and 2022. The Notice is favorable to employees.
The additional flexibility in recent legislation to allow carryovers and extended grace periods, as well as the increased contribution limit of $10,500 for the 2021 calendar year, left some confusion as to exactly how much could be reimbursed on a tax-favored basis during affected DCAP plan years.
Previous confusion around exactly what amount could be reimbursed by the DCAP during 2021 and 2022 on a tax-favored basis made some employers hesitant to implement any changes. Now employers can make such decisions with a better understanding of the tax impact on participating employees.
Simply put, Notice 2021-26 means that the increased amounts due to unlimited carryover, extended grace period or the increase in limit will not create taxation issues.
The notice, which includes several examples, confirms that amounts available in 2021 and 2022 due to a carryover or extended grace period will not count toward the $10,500 limit in 2021 or the expected $5,000 limit in 2022.
IRS Notice 2021-26 provided an exception to the general rule for leftover amounts from a previous plan year that continue to be available due to a carryover or extended grace period.
The general rule for DCAPs is that employees may be reimbursed up to $5,000 per calendar year (or up to $2,500 for individual who are married but filing separately) without having to include it in their taxable income. If the employee has money left over at the end of the plan year and takes advantage of a 2 ½ month grace period, any amount reimbursed above $5,000 during the calendar year must be included in taxable income.
With the exception provided in the recently released IRS Notice 2021-26, for the 2021 and 2022 calendar year, unused amounts from the previous plan year that continue to be available due to a carryover or extended grace period (as permitted by the CAA), will NOT count toward the annual maximum that may be reimbursed by the DCAP on a tax-favored basis.
For example, in 2021, individuals may contribute and be reimbursed for up to $10,500 in qualifying daycare expenses without having to include it in taxable income in addition to any amounts available for reimbursement due to a carryover or grace period applicable to the previous plan year.
Similarly, in 2022, individuals may contribute and be reimbursed up to $5,000 in addition to any amounts available for reimbursement due to a carryover or grace period applicable to the previous plan year.
IRS Notice 2021-26 can be found here.
Considerations for the Increased DCAP Contribution Limit for 2021
For employers still trying to decide whether to increase the 2021 contribution limit to $10,500, there are a few things to consider even now that the taxation uncertainty has been resolved by the IRS notice.
First of all, increasing the contribution limit guarantees employees up to $10,500 in tax-free reimbursement for qualifying daycare expenses during 2021 (plus any amounts allowed to be used from the previous plan year). However, keep in mind that even if the contribution limit is not increased, employees may be able to claim daycare expenses in excess of $5,000 on their tax return as a dependent care tax credit (which is a different program than the DCAP). The dependent care tax credit, normally with limits of $3,000 for a single child and $6,000 for more than 1 child, was increased to $8,000 for a single child and $16,000 for more than one child for 2021. Employees may be able to claim expenses that were not submitted to the DCAP for reimbursement (since no double-dipping permitted) as a dependent care tax credit.
Second, for DCAP plans that already struggle to pass discrimination testing, especially the 55 percent average benefits test, increasing the contribution limits, especially for highly compensated individuals, may make the plan even less likely to pass. We are not aware of any specific relief for §129 nondiscrimination rules related to this increase. Therefore, just as in other years, if a plan is discovered by the IRS to fail discrimination testing, the IRS could tax the benefits received by the highly compensated individuals.
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