Key Dependent Care FSA Concepts and Advantages
Why should you consider the Dependent Care Flexible Spending Account (FSA) this open enrollment season? Many have found the immediate tax advantages of the Dependent Care FSA a great way to put money back in your pocket throughout the year through payroll tax savings. We will review some key concepts and outline some of the advantages below.
What is a Dependent Care Flexible Spending Account (FSA)?
The Dependent Care Flexible Spending Account (FSA) provides tax-advantaged reimbursement for IRC § 129 “employment-related” expenses to provide custodial care for a qualifying individual.
Who is eligible to participate in a Dependent Care FSA?
Employees who are eligible to participate in their employer sponsored cafeteria plans that include a Dependent Care FSA that have work related child or adult daycare expenses are eligible.
- The care must be for a qualifying individual
- The participant and their spouse, if married, must keep up a home that they live in with the qualifying person or persons
- The participant and their spouse, if married, must have earned income during the year (special rules apply to spouses that are full time students)
- The participant must pay child and dependent care expenses so they and their spouse, if married, can work or look for work
- The participant must report the care provider on their tax return
The maximum amount that may be excluded for dependent care assistance during a taxable year (calendar year) is $5,000 ($2,500 in the case of a separate return by a married individual)
Who is a qualifying individual?
Benefits under a Dependent Care FSA are available for “qualifying individuals” of a taxpayer. Under Code § 21(b)(1) “qualifying individual” means: a dependent of the taxpayer as defined in Code §152(a)(1) (i.e., a qualifying child) who has not attained age 13; a dependent of the taxpayer who (1) is physically or mentally incapable of caring for himself or herself; and (2) has the same principal place of abode as the taxpayer for more than half of the year; or the spouse of the taxpayer, if the spouse (1) is physically or mentally incapable of caring for himself or herself; and (2) has the same principal place of abode as the taxpayer for more than half of the year. Code § 152(a)(1) defines dependent as a qualifying child or qualifying relative.
A qualifying relative is broad and may allow for unrelated individuals to be claimed as a dependent and may allow a domestic partner and pretty much anyone other than a spouse, to qualify as a dependent.
A qualifying child is an individual who (1) bears a specified relationship to the employee; (2) has the same principal place of abode as the employee for more than half of the year; (3) meets certain age requirements; (4) has not provided more than half of his or her own support for the year; and (5) for taxable years beginning after 2008, has not filed a joint tax return (other than only for claim of refund) with his or her spouse for the year.
Who is the qualifying individual when custody is shared in the event of a divorce?
A special rule applies for parents who are divorced, separated or living apart. In such cases, a child is a qualifying individual with respect to the custodial parent only – that is the parent having custody for the greater portion of the calendar year, no matter who is entitled to the tax deduction for the child. IRS regulations further define custodial parent as the parent with whom the child resides for the greater number of nights during a calendar year. When the number of nights with each parent is the same, the parent with the higher adjusted gross income is treated as the custodial parent.
What happens if one parent pays child support or is required to pay for the daycare for the children as part of the divorce decree?
Even if the noncustodial parent is financially responsible for providing childcare by order of the court, the custodial parent is the only one who can elect and be reimbursed under a dependent care FSA.
How is the Dependent Care FSA different from the Health Care FSA?
The Dependent Care FSA is not subject to the Uniform Coverage Rule. This means that FSA will not reimburse expenses until after that employee has deposited the funds into their account (amount deposited through payroll deductions and any employer contributions).
What types of expenses are eligible under the Dependent Care FSA?
Most commonly, the Dependent Care FSA can be used to reimburse work related dependent care expenses for children under the age of 13 unless unable for self care. However, work related expenses for an adult unable for self care may be eligible as well as long as the adult lives with you for at least 8 hours per day (i.e. spouse that lives with the employee and has Alzheimer's goes to day center so other adult can work).
Examples of common eligible dependent care expenses include babysitters in your home, nanny, daycare center, before school or afterschool daycare, preschool, summer camp.
What types of expenses are not eligible under the Dependent Care FSA?
The Dependent Care FSA cannot be used for expenses that are primarily educational, Kindergarten, Parochial School Tuition, Overnight Camp, Field Trips and Meals when billed separately, child support or fees paid to your spouse or other dependent children to watch your child under the age of 13 to name a few.
What is the maximum you can elect under the Dependent Care FSA?
The Dependent Care FSA has a statutory maximum of $5,000 per calendar year. In addition, unlike the Health Care FSA, the Dependent Care FSA has an annual family maximum. This family maximum can vary depending on the person.
The limits for the Dependent Care FSA are as follows (all applied on a calendar year basis):
- $5,000 if the employee is married and files a joint return or if the employee files as head of household
- $2,500 if the employee is married and files separately (both may elect $2,500 each)
- The employee’s earned income for the year (if less than the $5,000/$2,500 limits)
- The spouse’s earned income for the year (if less than the $5,000/$2,500 limits)
- $250 per month for one child or $500 per month for two or more children (not to exceed $5,000) if the spouse is a full-time student or unable for self-care.
What if my dependent care expense changes during the plan year? Can I change my election?
Mid-year changes are permitted if the employee has a qualifying change in status. The cost of coverage rules permit the employee to make changes to the Dependent Care FSA if there is change in cost associated with a change in provider, rates by a provider, change in work schedule impacting the need for care, etc. A mid-year changes to the Dependent Care FSA would be permitted as long as the change of status is filed with the plan typically no later than 30 days from the event.
What is the tax advantage to participating in the Dependent Care FSA?
Employees can save federal, state, social security and Medicare payroll taxes for their Dependent Care FSA salary reductions. That is like a mini-tax refund each time you have a payroll deduction. On average an employee can save 25% in payroll taxes for each $1 deducted pre-tax from payroll.
What do I need to do at tax time if I participate in a Dependent Care FSA?
The employer is required to report the amount of dependent care elections for the tax year to an employee in Box 10 of that employee’s W-2. The employee is then required to report their Dependent Care provider(s) and any Dependent Care FSA elections, and/or Dependent Care Tax Credit on IRS Form 2441.
If I participate in the Dependent Care FSA, can I also claim the Dependent Care Tax Credit (DCTC) on my income tax return?
An individual cannot claim the DCTC for day care expenses that were reimbursed tax free from the Dependent Care FSA. However, if there are eligible expenses in excess of the Dependent Care FSA pre-tax reimbursements, the individual can use the DCTC to whatever extent allowed by the credit.
The DCTC is available for day care expenses up to $3,000 for care of one qualifying individual (e.g., child up to age 13) and up to $6,000 for care of two or more qualifying individuals. Consequently, an individual who received less than the above amounts as reimbursement from their Dependent Care FSA can claim the excess expenses under the DCTC.
Which is better the Dependent Care FSA or the DCTC?
The DCTC is not a dollar for dollar tax benefit, unlike the Dependent Care FSA tax-free benefit: meaning the $5,000 Dependent Care FSA benefit reduces the employee’s W-2 taxable compensation from the employer by $5,000 and there is a payroll tax savings applied to each payroll deduction. The DCTC is a calculation you do at the end of the year on your federal income tax return and the employee is eligible for a percentage of the any dependent care expenses in excess of the Dependent Care FSA and any allowable DCTC. The DCTC ranges from 30% for individuals with adjusted gross income up to $15,000 to 20% for individuals with adjusted gross income over $43,000. So, at most, someone with any additional $1,000 they can claim in the credit may get a DCTC of $300.
The Bottom Line: At open enrollment this year, individuals should check with their tax adviser to determine which option or combination of options would be best for their scenario. Keep in mind that the DCTC may be available in addition for some individuals to claim a portion of their eligible day care expenses that were not reimbursed or paid tax-free through a Dependent Care FSA.