Dependent Care Assistance Programs
A Dependent Care Assistance Program (DCAP) is one method of providing employees with some assistance for their dependent care expenses.
How it works
Section 129 of the Internal Revenue Code allows an employer to establish a DCAP and pay up to $5,000 per year of employee dependent care expenses without having the value of the benefit taxable to the employee. This section of the Code regulates only those programs that are funded by the employer.
The only way to establish a Section 129 DCAP without a direct cost outlay from the employer is to offer a flexible spending account-type of cafeteria plan under Section 125 of the Internal Revenue Code. Under a cafeteria plan, an employee may voluntarily reduce his/her gross pay and elect to receive the reduction in the form of non-taxable benefits. Once the employee's pay is reduced, the amount of the reduction is treated as employer dollars for the purposes of the plan.
The Section 129 dependent care assistance plan is one of the non-taxable benefits that can be offered under a cafeteria plan. It is important to note that it is not necessary to have a full-fledged cafeteria plan in order to set up a DCAP.
Implementation
To establish a Section 129 plan, the employer must comply with the following requirements:
- The plan must be in writing and must be for the exclusive benefit of employees.
- Contributions or benefits must not discriminate in favor of highly compensated employees.
- The program may not discriminate regarding eligibility.
- The employer must notify all eligible employees that the program is available.
- The employer must provide an annual expense statement to all participants on or before January 31.
Each year employees participating in the plan designate the amount to be deferred for the entire year. Such amounts are excluded from gross income by the employer and reimbursed to the employee after the expense has been paid and a receipt submitted. The excluded amounts are not subject to federal income tax, Social Security, or state taxes. The current exceptions are Pennsylvania, New Jersey, and Alabama, where DCAPs are subject to state taxes.
Employees should carefully estimate their upcoming dependent care expenses at the beginning of each plan year. The amount elected cannot be changed during the year and any amounts remaining in the account at the end of the plan year must be forfeited to the employer unless the employee experiences a change in family status (e.g. birth, adoption, marriage, divorce, loss of a dependent or termination of the employee's or spouse's employment).
Eligible expenses
Only certain expenses may be reimbursed under the program:
- Household services provided that they are related to the care of the dependent — for example, maid or cook services.
- Actual care of the dependent.
Qualifying individual
The DCAP expenses must be for a dependent who is under the age of 13 or for a dependent who is mentally incapable of caring for him/herself, including elderly dependents. For separated or divorced parents, the parent with custody of the children may qualify for either the federal child care tax credit or a DCAP even if the noncustodial parent claims the children as dependents.
The dependent must spend at least eight hours per day in the employee's home. Therefore, overnight nursing home expenses for a parent do not qualify.
Dependent care options
A DCAP can be used to pay for a wide variety of dependent care options including care in the parent's home, in a private home, or in a licensed center. A licensed center must comply with all state and local laws. Reimbursement cannot be made to the employee's spouse or to one of the employee's children who is under the age of 19 at the end of the taxable year.
Requirements
To participate in the program, the employee must need dependent care services in order to be able to work or to look for work. If the employee is married, his or her spouse must also work, be a full-time student, or be incapable of caring for him/herself.
The correct name, address, and taxpayer identification number of the dependent caregiver must be included on the employee's tax return.
Dollar limitations
The amount reimbursed under a DCAP is limited to $5,000 per year ($2,500 for married individuals filing separately). Also, the reimbursement cannot exceed the employee's income, and in the case of married couples, it cannot exceed the lesser of their two incomes. For example, if one parent earns $25,000 and the other earns $3,000 from a part-time job, their reimbursement would be limited to $3,000 under a DCAP.
If the spouse is a full-time student or incapable of caring for him/herself, his/her income is assumed to be $200 per month if care is provided for one dependent, or $400 per month if care is provided for more than one dependent. In this instance, reimbursement would be limited to $2,400 and $4,800 respectively.
Effect of a DCAP on the Federal Child Care Tax Credit
Under The Family Support Act, effective beginning January 1, 1989, amounts reimbursed through the DCAP cannot be claimed as a child care tax credit (up to $2,400 for one dependent and $4,800 for more than one dependent) on the employee's federal tax return. For example, suppose an employee with one child puts $3,000 into a DCAP. Because $3,000 exceeds the maximum amount of expenses that can be used to calculate the child care tax credit for one child, no credit can be claimed. However, if the individual put only $1,000 into a DCAP, this person would still have $1,400 available to use in figuring the child care tax credit.
DCAPs vs. the Federal Child Care Tax Credit
Typically, higher income families benefit more from a DCAP than from the tax care credit. Child care experts offer the following general guidelines:
- By using a DCAP, higher income families can realize as much as 40% or more in savings on child care expenses, depending on their federal and state income tax brackets;
- Families with more than $25,000 of taxable income are usually better off using an employer-sponsored DCAP program;
- Families with less than $20,000 of taxable income are usually better off using the federal tax credits; and
- Families with taxable income of $20,000-25,000 should compare both options to determine which is better for them.
DCAPs and their relationship to the federal child care tax credit can be confusing. Employees need detailed information on how to make their choice (which the employer is obligated to provide), and some may still have difficulty in determining the most advantageous option. Each individual employee should determine (with the help of a tax advisor, if necessary) whether a DCAP will offer more savings than the tax credit prior to signing up for the DCAP program. It is possible that some families may be better off using a combination of the two options, but this can only be determined on an individual family basis.
Advantages and disadvantages
While a DCAP is an advantageous method of providing financial help in meeting dependent care expenses for many employees, some employees will not benefit from this type of program. The advantages and disadvantages are summarized below:
Advantages To Employees
- Employees have the ability to reduce their taxable income and use the income reduction to pay for dependent care expenses that would otherwise be paid with after-tax dollars.
Advantages To Employers
- There is a cost savings to the employer directly related to the amount of the total salary reduction for all employees. When salaries are reduced, the cost to the employer for benefits related to salary is decreased. The greatest savings to the employer will be on Social Security. The employer's savings are equal to 7.65% (for the 1990 tax year) of each dollar of salary reduction. This savings alone should more than compensate for the small administrative expenses of setting up the program.
Disadvantages To Employees
- "Use it or lose it" feature — Before 1990, federal tax law required that all unused money be forfeited to the employer. Beginning in 1990, employers can return unused money to employees, but must do it as a "dividend" or "experience gain," which means that it must be returned on a per capita or similar basis to all plan participants regardless of amounts unused by particular individuals. Determining each participant's share of the refund can be a complex and lengthy task. Accordingly, most employers continue to operate DCAP plans on a "use it or lose it" basis, and strongly resist bargaining proposals to refund unused money.
- As a result of reducing the gross salary, the employee automatically reduces the amount of gross wages for Social Security tax purposes. The earnings used to calculate an employee's Social Security benefit would not reflect the amount of deferral. While the Social Security benefit at retirement will not be significantly reduced, a young employee who has elected a large reduction and becomes disabled could receive a substantially lower Social Security benefit. Likewise, the survivor benefit could be lower.
- The employee's reduced salary may reduce other salary related benefits. Although nothing can be done about government required programs such as Social Security, workers' and unemployment compensation, the DCAP reduction does not have to apply to salary related programs such as pension, life insurance and disability income plans. Each of these plans can be amended to define salary as the unreduced amount without regard to DCAP reductions. However, some employers do it by including language in the DCAP plan itself that reductions under the plan shall not reduce these other plan's benefits.
- Reimbursement is made only after the expense has been paid. This could create a temporary cash flow problem until the plan reimburses the employee for the expenses paid.
- Amounts reimbursed under a DCAP cannot be claimed as a federal child care tax credit. Despite the relatively long list of disadvantages, it is important to reiterate that a DCAP can save many employees a significant amount of money, particularly in bargaining units where most employees have family incomes above $25,000.
If you have additional questions regarding DCAPs, please contact the Research Department at 202/429-1215.
AFSCME Research Department
April 1992