Certainty Creates Incentive for Increasing DCAP Limit

As discussed in our March blog post, the American Rescue Plan Act allowed employers with a qualified dependent care assistance program (“DCAP”) to increase the DCAP flexible spending limit in 2021 from $5,000 to $10,500. DCAP participants also received relief from the Consolidated Appropriations Act of 2021, to carry over unused DCAP benefits from a plan year ending in 2020 or 2021 to the following plan year. Although it was clear that a participant could contribute and be reimbursed from his account tax-free for $10,500 in 2021, it was not clear what the participant’s tax consequences would be if the participant carried over a DCAP balance from the prior year in addition to making contributions up to the $10,500 limit.

The IRS has now answered this question by issuing Notice 2021-26. The Notice grants participants additional relief by permitting tax-free reimbursements of amounts carried over from the prior year in addition to tax-free reimbursements of contributions made in the plan year up to the maximum limit. For example, a participant with a DCAP account balance of $15,500 in 2021 ($10,500 from 20201 contributions + $5,000 carried over from 2020) can be reimbursed from his entire account balance tax-free if he incurs $15,500 in dependent care expenses in 2021. The Notice also provides examples specific to non-calendar year plans.

Employers that were hesitant to increase their plan’s DCAP limit for 2021 to avoid unexpected tax consequences for their employees can lay those fears to rest with this most recent guidance. To implement the increased DCAP limit for 2021, plan amendments must be adopted by the last day of the plan year, although employers should act much sooner if they wish to implement the increased benefit for 2021. Employers will need to make participants aware of the increased benefit, and participants should be given time to spread contributions over as many pay periods as possible and prepare for the reduction in their paycheck.

If you want to provide this increased DCAP benefit to your employees, you should act quickly so participants can reap the full reward of the benefit. If you have questions about this issue or need help implementing the change, please contact any Graydon benefits attorney.

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