On May 10, 2021, the IRS explained in Notice 2021-26 that the dependent care assistance program balances carried forward under temporary COVID-19 relief provisions retain their exclusion from participating employees’ wages and gross income.
Dependent care assistance programs allow exclusion from gross income of employee amounts paid or incurred by the employer for the dependent care assistance provided. This benefit is typically offered to employees through a “cafeteria plan” as a flexible dependent care spending arrangement that will pay for or reimburse the employee for qualified dependent care expenditures. The exclusion is limited in employees’ tax years beginning before January 1, 2021, and after December 31, 2021. This income exclusion is limited to $5,000 per tax year ($2,500 for a married spouse filing separately) or, if less, the employee’s or employee’s spouse’s earned income for the tax year. For tax years beginning in 2021 only, those maximum dollar exclusions will be increased to $10,500 and $5,250 by the American Rescue Plan Act (ARPA). If the employer’s plan elects under Notice 2005-42, benefits remaining unused at the end of a plan year may be used during a resulting 2 ½-month grace period.
The Taxpayer Certainty and Disaster Tax Relief Act of 2020 (TCDTRA), Section 214 (a) and (b), allows an extended carryover of unused benefits from 2020 plan years to 2021 and from 2021 to 2022. Under Section (c)(1), however, plans may allow a 12-month extension of their claims period of plan years ending in 2020 or 2021. Notice 2021-15, issued by the IRS in February, illustrated that the temporarily extended carryover or claims period under the TCDTRA is not considered when determining the actual benefit limit for the year to follow.
Notice 2021-26, Section 129, clarified that dependent care assistance program benefits that would have been excluded if used during tax years ending in 2020 or 2021 remain eligible for exclusion from the employee’s gross income and disregarded for purposes of application of the limits for the subsequent tax years of the employee when they are carried over from a 2020 or 2021 plan year. The Notice also indicates the interaction of this relief with electing the maximum $10,500 benefit under ARPA for plan years beginning in 2021 and ending in 2022.