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The Dependent Care FSA

Is it better than the Child Care Tax Credit?

The IRS Code (Section 129) provides for "Dependent Care Assistance Plans" (DCAP), a method of employer-provided assistance for meeting dependent care needs of employees. Perhaps the most frequent type of DCAP is the Dependent Care Flexible Spending Account under a flexible benefit plan.

Brief Description

Employees can salary reduce on a pre-tax basis up to $5000 annually into a flexible spending account (FSA) for dependent care. Care must be for a child under age 13 or a disabled dependent meeting certain other requirements. Such salary reduction contributions are exempted from federal income tax, state income tax, and social security tax. The employee must then incur the expense and submit an appropriate third-party receipt for reimbursement. Upon approval of the expense, a tax-free reimbursement is made to the employee. Note that Dependent Care FSA reimbursements cannot exceed contributions for the plan year to date. This means that eligible childcare expenses can only be reimbursed as contributions are deducted from the employee's pay, and even though an expense may be eligible and approved, reimbursement will not be made until sufficient funds are contributed.

Why is the Dependent Care FSA considered an employer-provided plan?

Even though the benefit is being funded by the employee, the benefit is considered employer-provided because:

  1. The plan must be adopted by the employer and continuously meet a number of legal requirements.
  2. The employee enters into an irrevocable salary-reduction agreement for each plan year, agreeing to forego salary in consideration of receiving tax free reimbursement of qualifying dependent care expenses.
  3. The employer is legally responsible for the operation of the plan.

Please Note:

  • The employer must report the annual Dependent Care FSA amount on Box 10 of the employee's Form W-2 at year end. This is an informational figure for the IRS, and is not part of gross taxable earnings.
  • The employee doesn't "take a deduction" for these expenses on his/her tax return. Since there is a salary-reduction arrangement, the compensation is never earned... never reported on the Form W-2 at year end... thus, not taxed.
  • The employee is required to complete Form 2441 annually to be submitted with the tax return, just as is required for taking the Dependent Care Tax Credit
  • Special Considerations for Highly Compensated Employees*

What Is The Child Care Tax Credit?

The IRS Code (Section 21) provides for a "Dependent Care Tax Credit" for those paying for dependent care of a child under age 13, or for a spouse or dependent who cannot care for themselves. The expense must be necessary to allow the taxpayer (and spouse, if applicable) to work, seek work, or attend school.

Brief Description

To determine the available credit, a taxpayer can consider up to $3000/annually of child care expenses for one dependent, and a maximum of $6000/annually for 2 or more dependents. Depending on the taxpayer's adjusted gross income, the maximum credit (dollar-for-dollar offset of tax liability) is:

  • 30% ($720 annually for 1 child) for those earning less than $10,000 annually...
  • decreasing by 1% for each $2000 of additional annual income to...
  • 20% ($480 annually for 1 child) for those earning over $28,000 annually.

In other words, the higher your earnings, the lower your tax credit.

The Bottom Line

  • Which is Better for Me?