American Rescue Plan Act Expands Dependent Care Benefit—But Only for 2021

Davis Wright Tremaine LLP

Davis Wright Tremaine LLP

The just-signed American Rescue Plan Act (ARPA) contains several provisions to help multiemployer and single employer plans fund retiree benefits. Two less-noticed provisions greatly increase the child care tax credit and dependent care exclusion, but only for 2021.

To the extent children get back into school or daycare in 2021, and their care is needed to allow the parents to work, these increases could be valuable. It remains to be seen if efforts will be made to make these increases permanent.

Tax Relief Options

Previously, a parent or parents who incurred qualifying child or dependent care expenses to enable them to work had two avenues for tax relief.

First, they could claim a tax credit up to 35 percent of the first $3,000 of expenses for one child under 13 (or adult dependent needing at-home care) or $6,000 for two or more children. The second was to exclude from taxable income up to $5,000 in employer-paid dependent care expenses ($2,500 if married filing separately), typically paid through a salary-reduction dependent care account under a cafeteria plan.

These tax benefits could be combined but cannot both be used for the same expense. For example, a parent with one child could take the tax credit for the first $3,000 in expenses and pay the next $5,000 through a dependent care account.

The limitations on these benefits are not indexed and have not changed for many years, so they no longer cover the child care expenses many working parents incur. ARPA increases the limits on both benefits for tax year 2021 only.

Child Care Tax Credit Increase

The child care tax credit is increased to up to 50 percent of $8,000 in expenses for one child or $16,000 in expenses for two or more children, and is made refundable. Thus, even parents who owe no income taxes can take advantage of the credit.

The percentage phases down for taxpayers earning between $125,000 and $400,000 in gross income phase-out used to start at only $15,000. These changes will make the tax credit more attractive to middle-class and professional parents, who usually got more out of the dependent care exclusion under the prior rules.

Dependent Care Exclusion Increase

The dependent care exclusion is also sharply increased for 2021 only, to $10,500 ($5,250 if married filing separately). ARPA provides that a cafeteria plan will not be in violation of the applicable rules if it is amended retroactively by the last day of the plan year in which the amendment is effective and operates consistently with the amendment.

Presumably this is intended to allow plans to let participants immediately increase the amount that they had previously elected to defer to a dependent care account for 2021, in order to take advantage of the increased exclusion. Participants who carried over unused amounts from 2020 to 2021 will also be able to take advantage of the higher exclusion for reimbursements in 2021. (See our previous article on relief for benefits plans contained in the Consolidated Appropriations Act of 2021.)

Although the use-it-or-lose-it rule poses a risk to amounts deferred into a dependent care account, the CAA of 2021 also allows a plan to adopt an unlimited carryover of unused amounts from 2021 to 2022. Besides the income tax savings from this exclusion, salary reductions through a cafeteria plan are also excluded from FICA tax (for both the employee and employer).

For the dependent care exclusion, employers should consider whether a plan amendment is needed to increase the dollar limit (if it is specified rather than just linked to the statutory limit) and to allow mid-year election changes. Also, employers with a dependent care account are required to explain the alternative of using the child care tax credit, so that explanation should be supplemented even if the dependent care plan is not changed.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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