The IRS Code (Section 129) provides for "Dependent Care Assistance Plans" (DCAP), a method of employer-provided assistance for meeting the dependent care needs of employees. The most popular type of DCAP is the Dependent Care Flexible Spending Account offered through a flexible benefit plan. Employees can salary reduce on a pre-tax basis up to $5000 annually into a flexible spending account (FSA) for dependent care. The care must be for a child under age 13 or a disabled dependent meeting certain other requirements. Such salary reduction contributions are exempt from federal income tax, state income tax, and social security tax. Once the employee incurs an expense, the employee must submit an appropriate third-party receipt for reimbursement. Upon approval of the expense, a tax-free reimbursement is made to the employee.
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:
- The plan must be adopted by the employer and continuously meet a number of legal requirements.
- 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.
- The employer is legally responsible for the operation of the plan.
Special Considerations for Highly-Compensated Employees
The Dependent Care contributions of highly compensated employees are subjected to a unique non-discrimination test, one of several such tests applicable to flexible benefit plans.
The "Average Benefits Test" essentially states that the plan must:
- Classify its employees into two groups, "Highly Compensated" (HC) and "Non-Highly Compensated".
- For each group, the average Dependent Care FSA contribution must be calculated.
- The average for the non-highly compensated group must be at least 55% that of the average of the highly compensated group.
Observations: (Regardless of whether it makes sense, these are the rules!)
- In calculating these averages, the plan must include everyone - not just those selecting Dependent Care. Example: If there are 10 non-highly compensated, with only 1 participating in the Dependent Care FSA at $400/month, the average contribution is $40/month.
- For salary reduction flex plans (the most common type), those earning less than $25,000 annually may be disregarded for purposes of this test. [Why? It is presumed that the law assumes those earning less than $25,000 annually are sufficiently benefited from the Dependent Care tax credit available to all taxpayers.]
If you are a Highly Compensated employee, the allowable amount of your Dependent Care FSA may be limited by the levels of participation of others in the plan.
What Is A "Highly-Compensated Employee?"
"Highly compensated" is a term with various meanings under the law, depending upon the specific point of reference. In this case the definition outlined in Section 414(q) applies. The 1996 amendments to Sec. 414(q) greatly simplified the definition of highly compensated employees. As amended, Sec. 414(q)(1) defines a highly compensated employee as any employee who:
- was a 5% owner at any time during the year or the preceding year, or
- had compensation in excess of [indexed: $110,000 for 2011 and 2010] in the preceding year and, if the employer so elects, was in the "top-paid group" of employees for the preceding year. As defined by Sec. 414(q)(3), the "top-paid group" of employees for a given year is the top 20% of employees ranked on the basis of compensation received during that year.
Dependent Care FSA vs. 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.
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
A generalization is that those with less than a 15% tax bracket will be better served by the Dependent Care Tax Credit. IRS Publication 503 "Child and Dependent Care Expenses" provides full information about this tax credit and offers worksheets and aids for performing the calculations.
Which is Better for Me?
This is the fundamental question. We will attempt to answer it on several levels:
- If you are earning a moderate to high income, and particularly if you are filing taxes as "Married, Filing Jointly" (combining incomes with a spouse), the Dependent Care FSA is probably more advantageous. Reasons: Your tax bracket is probably higher than 15%, the threshold generally regarded as the dividing point between the Dependent Care Tax Credit (best for those earning LESS) and the Dependent Care FSA (best for those earning MORE).
- Logically, if you have 1 child, the $5000 available through the Dependent Care FSA is probably more generous than the credit arising from the $3000 limit imposed by the Dependent Care Tax Credit. (See section on Dependent Care Tax Credit, above.)
- Finally, the FSA saves not only income taxes (federal and state), but social security taxes as well. There are no social security tax savings offered by the Dependent Care Tax Credit. (Note: Your social security benefits could be slightly reduced by paying less social security taxes.)
- Some assistance is provided by the IRS Publication 503 "Child and Dependent Care Expenses", which provides full information about the tax credit and offers worksheets and aids for performing the calculation.
- A more precise analysis can be made by your tax advisor. We recommend that in all matters regarding legal and tax counsel, the services of qualified legal and tax counsel be sought.
- 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
Want to learn more about how Dependent Care FSAs can benefit your employees and you?