Today we live in an income tax environment full of phase-outs, surtaxes, penalties, and credits. One bright point of our complex tax environment is we have options! As tax professionals, we strive to utilize the options that result in more tax efficient ways for our clients to do what they are already doing. One of the tools we consider is the use of a Dependent Care Flexible Spending Account. If a Dependent Care FSA is not right for you, we can always fall back on the dependent care credit.
Dependent Care FSAs are plans offered by employers, typically as part of the employer’s cafeteria plan of benefits. Employees can contribute up to $5,000 ($2,500 married filing separate) per year to a Dependent Care FSA and use the funds to pay for the dependent care costs. Contributions are typically made on a pre-tax basis resulting in less taxable income on your Form W-2. In some cases, reducing taxable income will increase other credits and deductions. One of the downsides about using a Dependent Care FSA is that contributions lower qualifying expenses for the dependent care credit.
The dependent care credit is a nonrefundable 20% to 35% credit for dependent care expenses. Taxpayers can use up to $3,000 of expenses per qualifying person ($6,000 max for two qualifying persons) for dependents under age 13, a spouse not physically or mentally able to care for themselves, or a dependent (with some exceptions) not physically or mentally able to care for themselves. The credit percentage is based on the earned income of the taxpayer and spouse. In most two-earner households the credit will be 20%. In short if you spend $6,000 a year on dependent care expenses and receive a 20% credit the credit will be $1,200 to offset your current income taxes.
One important item to note is the dependent care credit and dependent care FSA deduction are dependent on both the taxpayer and spouse having earned income (if filing a joint return). Eligible expenses cannot exceed the earned income of the lowest earning spouse.
Now comes the tricky part. Depending on your tax situation, a dependent care FSA could reduce or increase your overall income taxes.
You can benefit from a Dependent Care FSA if you…
- are in a tax bracket of 25% or more
- are being phased out of deductions or credits
- have only one child eligible for dependent care expenses
- earned income credit is being reduced due to increased income
Let’s check out some examples!
Example 1: in 2015 a married couple files a joint return, earns $110,000 in taxable wages and has two dependents under age 13 with $6,000 of total dependent care expenses. Below we compare the tax outcome from not using a dependent care FSA versus contributing $5,000 to a dependent care FSA.
In example 1 the couple saved 5% or $250 on the $5,000 FSA contribution.
Example 2 is the same as Example 1, but taxable wages are now $140,000.
In example 2 the couple saved 10% or $500 on the $5,000 contribution. The savings is due to reduced income tax and an increased child tax credit.
Example 3 is the same as Example 2, but the taxpayers now have student loan interest of $2,500.
In example 3 we see how the income tax savings grows as the tax situation becomes more complex. The student loan interest is being reduced due to income limits. Reducing taxable income increases the student loan interest deduction while increasing the child tax credit.
We have seen how a Dependent Care FSA can help higher income earners, but how about lower earning households?
In example 4 we have a married couple earning taxable wages of $40,000 and paying $6,000 in dependent care expenses for their two qualifying dependents.
In example 4 we see how reducing taxable earned income can increase the earned income credit resulting in a larger income tax refund.
A Dependent Care FSA can be a great tax-savings tool for you and your family. Call your tax advisor to see if you can benefit.