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Dependent Care: FSA or Tax Credit?

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Written by Jason Cogdill on 03 November, 2014
Dependent Care: FSA or Tax Credit?

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.

Dependent Care Tax Credit

The IRS Code also 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.

Sounds great. What's the catch?

The IRS won't allow double-dipping. You can either use a Dependent Care FSA or take the Dependent Care Tax Credit, but not both.

So Which is Better for Me?

Generally speaking, 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.

Specifically:

  • 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.

Have more questions about Dependent Care FSAs?

 

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Comments  

0 #1 D 2016-08-30 10:52
Can someone walk me through using the FSA in practical terms? I spent $1,100/month in day care (2 kids). Based on everything I read, because of the tax benefits, it would be advantageous to do the FSA. But if max is $5k, then my employer takes $192/pay out of pay check? But then each month, I'd some how transfer $384 from the FSA to daycare provider, but pay remaining $800 out of pocket? What about like December 21st paycheck. Employer takes out the $192, but I already paid Daycare for the month. I just lose it? since it doesn't roll over?

I want to take advantage of the tax break, but it all just seems like a pain to track/pay, etc. Am I making it out to be harder than it actually is? Thanks for any practical examples!
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0 #2 Christopher Macali 2016-09-06 14:19
Thanks for your comment. The Dependent Care FSA allows employees to exclude up to $5,000 of salary from taxable income each year in order to pay for child care expenses for qualifying children. By electing to participate in the Dependent Care FSA, the employee agrees to allow the employer to withhold a portion of the employee’s salary each pay period. Once the employee incurs a qualifying dependent care expense, the employee can request reimbursement from the employer. Unlike the Health FSA, a Dependent Care FSA participant can only receive reimbursement for an expense up to the amount withheld from the employee’s salary up to that point in the year.

As a practical example, let’s assume an employee elects to contribute $5,000 for the plan year to the Dependent Care FSA. The employee is paid twice per month, so the employer will withhold $192 each pay period ($5,000 / 26 pay periods). The employee incurs $1,100 of child care expenses in the first month of the plan year, pays for the expense out-of-pocket, and submits a claim for reimbursement. Upon receiving the claim at the end of the first month, the plan will reimburse the employee $384 tax free (the amount that has been withheld from salary after 1 month). The remaining $716 of the expense can be reimbursed in following months once more salary is withheld from the employee.

Although this reimbursement schedule can cause a cash flow issue on the front end, an employee that incurs $5,000 of child care expenses during the plan year should not lose any Dependent Care FSA contributions. The employee in our example would have incurred $5,000 of child care expenses by the end of the 5th month of the plan year and can receive reimbursement for the $5,000 throughout the remainder of the plan year as contributions continue to be withheld from the employee’s salary. To simplify reimbursement, after $5,000 of expenses have been incurred, the employee can submit substantiation for approval of all $5,000. Upon approval, automatic reimbursement can be set up so the participant is reimbursed regularly when the contributions are withheld. The reimbursement frequency may vary depending on the plan.
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