Child care is expensive, and many families are struggling to pay unexpected care costs while their kids are at home with virtual school or their preschool and after-school programs are closed because of COVID-19. A dependent care flexible spending account can provide tax-free money for these expenses and help you stretch your child care dollars.
If your employer offers a dependent care FSA, this is a particularly important year to consider enrolling in the account during open enrollment season. And if you already use a dependent care FSA, it’s a good time to reassess your care costs and change your contribution level if needed. You may have little or no opportunities to make changes midyear, and this is not the time to keep your dependent care FSA decisions on autopilot. Here’s how to make the most of this valuable benefit.
Who Is Eligible for a Dependent Care FSA?
Most large employers offer a dependent care FSA, which lets you set aside up to $5,000 per household to pay child care expenses for kids under age 13 while you and your spouse work or look for work. The cost of day care, preschool (but not tuition for kindergarten or older), a nanny or babysitter, before- and after-school care, and even day camps during the summer or school breaks are eligible. Overnight camp doesn’t count.
Dependent care FSA contributions are pretax, which means they escape federal, state and Social Security taxes, and the money can be withdrawn tax-free for eligible child care expenses.
Using pretax money for child care costs can save you hundreds of dollars or more. For example, if you contribute the maximum $5,000 in a year and are in the 24% tax bracket, you could save about $1,583 a year in taxes, including both federal income tax and the 7.65% Social Security and federal tax, says Kimberly Tippens, senior director of benefits accounts for Willis Towers Watson, a benefits consulting firm. You can then use that money tax-free for child care expenses.
“My clients tend to take advantage of the dependent care FSA as long as they are confident that their child care expenses will meet or exceed the FSA limit,” says Natalie Taylor, a certified financial planner in Santa Barbara, California. “With child care expenses for my clients at $1,000 to $2,500 per month, dependent care FSAs are a great option.”
The downside to dependent care FSAs is that you usually have to use the money in the account by the end of the year or you lose it. Some employers offer a grace period until March 15 of the following year to use the money, but that is unusual — Tippens estimates that only about 10% of the employers they work with have adopted grace periods for dependent care FSA.
“Since dependent care FSAs are use-it-or-lose-it, I recommend that clients be conservative in their estimate of child care costs,” Taylor says. “If there’s a decent chance they won’t spend the money, the tax break isn’t worth it.”
What if My Child Care Needs Change During the Year?
It’s important to think carefully about how much you may have in child care costs for the upcoming year when signing up for the dependent care FSA because you have limited options to make changes after open enrollment is over. But it can be difficult to estimate your yearlong expenses now, with so much uncertainty about school and jobs. However, there are some situations where you can change your contributions during the year.
“Employees are generally locked into the amount they elected when they enrolled, with no midyear changes allowed — unless there’s a change in family status, such as birth, divorce, marriage or death,” Tippens says. “Other permitted changes that an employer may allow include change in the cost of care or loss of dependent eligibility, such as a child turns 13 or a disabled relative is now able to care for themselves, or a change of employment status for you or your spouse.”
The Coronavirus Aid, Relief, and Economic Security Act let employers add a special midyear open enrollment period in 2020 when employees could start, stop, increase or decrease their contributions for other reasons, but that was a special situation.
“Because COVID caused some child care expenses to go up and some to go down, I did have a couple clients who needed to adjust their dependent care FSA election if they lost care,” Taylor says. “But for many, myself included, COVID caused child care expenses to go up with elementary-aged children doing school at home.”
Unlike health care FSAs, where you can access the entire amount you plan to contribute for the year on Jan. 1, you can only use money from the dependent care account after you make the contributions from your paychecks. “The amount available for reimbursement at any time is the amount actually contributed minus paid claims,” Tippens says.
Which Is Better: Dependent Care FSA or Child Care Tax Credit?
The child care tax credit offers similar benefits as the dependent care FSA: With both types of accounts, the break applies to child care costs for kids under 13 while you work or look for work. The types of child care costs that count are also the same. But the way the tax break is calculated is different. The dependent care FSA is usually a better deal, especially as your income gets higher.
The child care tax credit can be worth 20% to 35% of up to $3,000 in child care expenses if you have one eligible child, or up to $6,000 in expenses for two or more children. The lower your income, the larger the credit. There’s no income limit to qualify. If you earn more than $43,000, the credit is worth 20% of your eligible child care costs, which can result in a tax break of up to $600 if you have one eligible child or $1,200 for two or more children.
“While both the tax credit and a dependent care FSA both provide tax advantages, the FSA plan provides the greatest tax advantage, especially for those with one child,” Tippens says. “For those with two children, they can maximize the tax savings by contributing $5,000 for the dependent care FSA and claiming the additional $1,000 dependent care tax credit.”
You can’t claim the child care tax credit for the same expenses you paid from a dependent care FSA, but there is one situation where you might be able to benefit from both tax breaks: The dependent care FSA limit is $5,000 per household, no matter how many children you have. But if you have two or more children under 13, you can usually claim the child care credit for up to $6,000 of expenses. That means if you have two or more kids and $6,000 or more of child care costs, you may be able to claim the child care tax credit for the extra $1,000 of expenses, which could reduce your tax liability by an extra $200 to $350, depending on your income.
If your employer doesn’t offer a dependent care FSA, or if you didn’t sign up during open enrollment, you can still take the child care tax credit — which is good to keep in mind when filing your 2020 income tax return if you suddenly had new child care needs in the middle of this year because of COVID-19.
Another difference between the dependent care FSA and the child care tax credit is administrative requirements. For the child care tax credit, you need to include the care provider’s Social Security number or the day care, camp or preschool’s tax ID on your income tax return, then keep receipts of your expenses in your tax files. A dependent care FSA administrator may ask for much more detailed information before letting you tap your account. “All claims must be substantiated and the claim administrator will need (at a minimum) documentation that includes the dates when care was provided, who provided the care (name, address, and possibly tax identification or Social Security number), description of the care and the amount charged,” Tippens says. “Credit card receipts, canceled checks and balance due statements typically don’t provide all of the detailed information.”
Can I Use the Dependent Care FSA for Aging Parents?
Dependent care FSAs aren’t just for kids. If you’re supporting elderly parents, then you may be able to set aside pretax money to pay for their care, too. But they need to meet several requirements: They must be your dependent for tax purposes, they must reside with you, and you must provide at least 50% of their support. They must be physically or mentally unable to care for themselves, and the elder care must be provided so you and your spouse can work or look for work.
If they meet these requirements, you can use the dependent care FSA for a variety of elder care expenses. “Eligible expenses may vary based on the employer’s plan, but some common expenses include adult day care centers, senior care, care at home or someone else’s home, and transportation from home to the caregiver’s facility,” Tippens says.
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