Does your employer offer a dependent care flexible spending account? If you are already making pre-tax contributions, you might consider increasing your contributions to the new annual limits signed into law by the American Rescue Plan Act in March 2021.

2021 Annual Contribution Limits

  • $5,250 for single taxpayers (up from $2,500)
  • $10,500 for married couples filing jointly (up from $5,000)

Why is this beneficial?

Pre-tax contributions lower your taxable income reducing your Federal Income Tax. In addition, these contributions also avoid the 7.65% Social Security and Medicare tax.

For example, a married filing joint couple in the 22% tax bracket, making max FSA contributions of $10,500 would have a total tax savings of $3,113 or 29.65% ($10,500 x 22% + 7.65%).

What if I am unable to use all of my 2020 & 2021 contributions?

Prior to the 2020 COVID pandemic, dependent care FSA contributions were typically “use it or lose it” in the year contributed. However, IRS Notice 2021-26 clarifies that an employer can modify their FSA plans to allow unused funds from 2020 to roll over into 2021, and 2021 funds into 2022.

What’s more unused amounts carried over from a prior year or available during an extended grace period won’t be taken into account in determining the annual contribution limit for the following year.

In addition to dependent care FSAs, the American Rescue Plan Act has modified the child and dependent care credit with the taxpayer in mind. Prior to 2021, the child and dependent care credit was most advantageous for the lower income taxpayer due to the credit percentage quickly decreasing from a max 35% to 20% starting at an adjusted gross income (AGI) of $15,000.

What’s new with the child and dependent care credit?

  • Qualifying expenses increased to $8,000 for one child (was $3,000) and $16,000 for two or more (was $6,000)
  • Maximum credit is now 50% (was 35%)
  • Credit reduction now begins at an AGI of $125,000!
  • Credit is now refundable.

Dollar for dollar, this credit is huge. In a pre-COVID world, it was not hard to incur annual childcare expenses of $8,000. For 2021, a single taxpayer or working couple with an AGI less than $125,000 who spends $8,000 in childcare expenses will receive a $4,000 tax credit! In addition, now any amount of the credit above your tax liability is not lost; it’s refunded.

One thing to keep in mind is that dependent care FSA contributions cannot be used for the child and dependent care credit.

As with anything in life, planning is key. Speak with your tax professional at Ketel Thorstenson today to see which of these tax law changes could benefit you most.