8894 / Is there a limit to the amount that an employee may exclude for payments paid by an employer under a dependent care assistance program?

Editor’s Note: The American Rescue Plan Act (ARPA) allowed employers to increase contribution limits for dependent care assistance programs to $10,500 for 2021. The 2021 CAA also allowed participants to carry over unused DCAP benefits from 2020 or 2021 into the following plan year. Initially, there was some confusion over the tax consequences if a participant took advantage of both the increased contribution limit and carryover relief. Notice 2021-26 clarified the issue by providing that participants may take advantage of both (1) tax-free reimbursements of contributions made during the 2021 plan year up to the maximum $10,500 limit and (2) tax-free reimbursements of amounts carried over from the prior year. In other words, a participant with a $5,000 carryover amount from 2020 and a $10,500 contribution in 2021 could take tax-free distributions up to $15,500 in 2021 if that participant incurred enough qualifying expenses during the 2021 plan year. See below for a discussion of the otherwise applicable limitations.

An employee may exclude up to $5,000 paid by the employer for dependent care assistance provided during a tax year.¹ The excludable amount is reduced to $2,500 for a married individual filing separately. Additionally, the excludable amount cannot exceed the earned income of an unmarried employee or the lesser of the earned income of a married employee or the earned income of the employee’s spouse.²

An employee cannot exclude from gross income any amount paid to an individual with respect to whom the employee or the employee’s spouse is entitled to take a personal exemption deduction under IRC Section 151(c) (prior to 2018, when the personal exemption was suspended for 2018-2025) or who is a child of the employee under 19 years of age at the close of the taxable year, or the spouse.³

If the dependent care assistance is provided by way of on-site facilities (such as an on-site day care center), the amount of dependent care assistance excluded is based on a dependent’s use of the facilities and the value of the services provided with respect to that dependent.⁴