The IRS allows families to get tax relief for the cost of caring for children or other dependents. This is especially helpful as more families caring for young children also take in elderly parents rather than put them in a care facility or hospice. One plan offered by some employers is the dependent care Flexible Spending Account (FSA). The dependent care FSA shares some similarities with the more common healthcare FSA. Some of the restrictive provisions, such as the "use it or lose it" provision keep FSAs from being more popular, but it can be an important tax planning tool for many families.
What Is a Dependent Care FSA?
A dependent care FSA is a tax-advantage plan offered by employers and approved by the IRS. It allows plan subscribers to deposit funds from their paychecks into the plan throughout the year, which can then be used to pay eligible care expenses. This type of FSA can be used in tandem with, or instead of, claiming the dependent and child care tax credit on the end of year tax return. The plan is only offered through an employer and cannot be subscribed to otherwise. As with any other IRS-approved plans, there are limits. Eligibility requirements and other rules that must be met in order to set up and use a dependent care FSA. Each plan works a little differently, but the basic rules and limitations are still the same.
Who Is Eligible?
The purpose of the plan is to allow working individuals a tax benefit for paying for child or other dependent care that allows the taxpayer to work. In order to be eligible to claim the benefits of a DCFSA, both spouses must either be working or looking for work. Eligibility also extends to those who are incapable of working due to a physical or mental impairment and to those who are in school full time.
The dependent must reside in the same house as the taxpayer and be otherwise able to be claimed as a dependent. This residency requirement is daily, If the dependent only lives with you for a portion of the year, you may only claim expense reimbursement for costs incurred during that period.
Eligible claimants include:
- children under 13
- elderly parents or other tax dependents (such as children 13 or over) who cannot care for themselves due to a physical or mental impairment
- a spouse who requires care
You can contribute a maximum amount to your DCFSA of $5,000 per year if you are married and filing jointly with your spouse or if you are single. You are limited to $2,500 annually if you are married and filing separately. Most plan contributions are made directly through payroll deductions. Your total annual estimated dependent care costs are divided by the number of paychecks in a year and that amount is taken directly off the check. This reduces taxable income on every paycheck and spreads the benefit throughout the year. Federal and state taxes, as well as Medicare and Social Security deductions, are calculated on the income net of contributions. Unlike a healthcare FSA, the plan is not pre-funded by the employer, and you can only spend up to what you have in the account at any point in time. For example, you may plan to spend $4,000 on day care fees for the year but may only have $1,200 in the account early in the year when an installment is due. You will only be reimbursed $1,200 until you build up more contributions.
Most expenses that relate to caring for your dependents in order to allow you to work are eligible. These include:
- day care or daytime adult care facility expenses
- home care expenses, including those of employing a nanny-housekeeper
- summer day camp expenses (while the parent is not on vacation)
- before-school and after-school care
- any deposits paid on other eligible expenses as long as the care was later provided
- child support payments
- overnight camp expenses
- any expenses related to education, such as field trips
- tuition at private schools
- kindergarten costs
- medical care expenses
- activities such as sports fees, music lessons, or service organization memberships
- expenses for services provided by any of your other tax dependents, including minor children
- housekeeping services not provided in tandem with child or dependent care
- live-in hospice or nursing home costs
How Reimbursement Works
There are two main ways to manage eligible expenses on a DCFSA. Some plans attach debit cards so that you can pay expenses directly to the care provider. This way, as long as the expenses are eligible, you don't have to be out of pocket for the expense. Most plans, however, still work on the reimbursement model. You will pay the expense out of your own money to the provider, then fill out paperwork to get a reimbursement check or direct deposit from the plan administrator. This can take several weeks before you get your money back, so it's important to plan spending accordingly. You will also have to submit expense receipts with the reimbursement request that contain the date of the expense, type of expense, and details of the provider, such as social security numbers for individual care givers. You can only claim expenses incurred within the plan year, although some plans allow for a grace period of one or two months at year end.
Dependent Care FSA Vs. Child and Dependent Care Tax Credit
The IRS sets the same eligibility requirements for the Child and Dependent Care Credit (CDCC) as for the dependent care FSA. The same expenses also qualify. The tax benefit works fundamentally differently, however. The FSA allows the expenses to be deducted from your taxable income; therefore, the amount of benefit changes depending on your income and tax bracket. The higher your income, the higher your tax savings. On the other hand, the CDCC is a credit that is a percentage of the expense. The percentage decreases as income rises. The credit starts at 35% for income up to $15,000 to 20% for income over $43,000. Therefore, the higher your income, the lower the tax benefit. The credit is deducted directly from the tax balance owing at the end of the year. The CDCC also caps eligible expenses at $3,000 for one dependent and $6,000 for two or more, up to a maximum of 100% of the annual income of the lower-earning spouse. For example, if you earn $40,000 and your spouse earns $2,000, you will be able to claim expenses up to a maximum of $2,000 only.
You may have both a dependent care FSA and be eligible to claim the credit but not for the same expenses. You can choose either vehicle to claim the tax benefit of an expense depending on which gives you the largest tax break.
There are some issues to consider when deciding to subscribe to your employer's DCFSA:
- you must use all of your contributions in the year on qualified expenses, otherwise, you forfeit them. You cannot carry a balance in your account from year to year. This is known as the "use it or lose it" provision.
- once you determine your funding levels, you cannot change your contributions unless you have a qualifying event, such as a marriage, a baby, a death or a divorce. In those cases, you have a short window, usually 30 days, to make changes to your contribution levels.
- you will need to fill out IRS Form 2441 to determine your eligible expenses and file it every year with your tax return.
Tax Planning Strategies
Whether it makes more sense to claim dependent care costs under an FSA or the tax credit depends on your and your spouse's situation and taxable income levels. In general, an FSA will provide a larger tax benefit to those in higher tax brackets. In tax brackets lower than 35%, the credit will exceed the FSA deduction. If one spouse makes very little taxable income (as may be the case with self-employed individuals), the credit may be capped at a lower amount than allowable with the FSA. In one-dependent families, the FSA allows up to $5,000 in eligible expenses, whereas the tax credit is limited to $3,000. When there are two or more dependents, the credit allows $6,000 versus $5,000. Because the tax credit is not refundable and the FSA allows only a deduction up to 100% of combined taxable income, you may wish to defer other deductions and credits, such as for donations, that can be carried forward, allowing you to maximize the dependent and child care benefits.
The Bottom Line
Setting up a dependent care FSA with your employer can help manage significant expenses when you have to find care for children or other dependents. It should be managed carefully to ensure that you use up all of your contributions and don't lose them. Calculate the tax savings for both the DCFSA and the CDCC to ensure that you pick the option that benefits you and your family the most.
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