No expense has skyrocketed more for parents over the past 20 years than the cost of child care. According to a recent report by Care.com, American families now drop an average of $9,697 per year on daycare or pre-school, or around 16 percent of their annual income. This comes despite recommendations by experts that they should allocate no more than seven percent of their household’s budget to child care. Worse still, rising daycare costs show no signs of leveling off, ensuring middle-class families will be further squeezed as they struggle to pay for affordable child care.
There are, however, ways to save money on daycare with the help of Uncle Sam. While most parents are aware of the Child Care and Dependent Tax Credit ⏤ which allows for the deduction of eligible care-related expenses from federal taxes ⏤ many haven’t heard of Dependent Care Flexible Spending Accounts (DCFSA), and as a result are leaving a lot of money on the table when it comes to daycare costs. Next to the Child Tax Credit and the Child and Dependent Care credit, it’s the IRS’s third way of offering parents relief from the burgeoning costs of raising kids.
Similar to other flexible spending accounts, Dependent Care Flexible Spending Accounts are special tax-advantaged accounts offered by an employer to be used specifically to pay for expenses associated with child or dependent care. It essentially lets parents pay for daycare with pre-taxed income, and depending on their marginal federal and state tax rates, they can save families up to $2,000 a year.
A recent survey of employers found that 67 percent now offered their employees a Dependent Care Flexible Spending Account, although a report by the Bureau of Labor and Statistics notes that access often depends on the type of job one holds, with “management, professional, and related occupations generally offer greater access to benefits than do service occupations.” Still, if a DCFSA is part of your employer’s benefits pack, it can be a great way to defray the costs of daycare, babysitters, and even assistance for an aging parent.
But how do Dependent Care Flexible Spending Accounts work? Who’s eligible? And how can you take advantage as a new parent? Fatherly recently spoke to Matt Becker, a Florida-based CFP and the founder of Mom and Dad Money, to get all the details.
Who Is Eligible to Set up a Dependent Care Flexible Spending Account?
Simple, anyone who works for a company that offers a Dependent Care Flexible Spending Account as part of the benefits package. If you’re using the money to pay for child care expenses, the kid must be 13 years or younger. If it’s for a spouse or adult dependent, they must be physically or mentally unable to care for themselves. Unfortunately, you can’t set one up independently with the federal government and then ask your employer to participate. As noted though, access to dependent care reimbursement accounts is on the rise with 67 percent of companies reporting that they offer one, up by some accounts from around 54 percent four years ago. While Health Care FSAs have dipped somewhat since 2014, employees are allowed to maintain both a Dependent Care FSA and a Health FSA to offset medical expenses, says Becker.
What Qualifies as an Eligible Expense?
“The IRS has guidelines about what qualifies as dependent care,” Becker says, “But, generally, if you’re paying for care for a child or other dependent so you can work, that counts.” The catch is that both parents need to be working and making at least $5,000 per year, which is the maximum contribution allowed by the IRS. “If you’re not working, then it doesn’t count,” Becker adds, “Because you don’t need the benefit.”
As for which specific expenses are eligible, the IRS lists them on its website and they’re the same ones that can be deducted with the Dependent Care Tax Credit. They include everything from a daycare center, Au Pair, or afterschool program, to an in-home nanny, preschool, or summer day camp. Here’s a breakdown of what expenses are and aren’t covered.
How Does a Dependent Care Flexible Spending Account work?
After setting up DCFSA with your company during the open enrollment season (usually the end of the year), they’ll deduct a specific amount of pre-tax money from each paycheck and transfer it into the account. Then you cover child or dependent care expenses out of pocket and submit receipts for reimbursement. It’s pretty much just like filling out an expense report at work. It’s all handled online and the money is usually deposited directly back into your bank account. “The expenses need to be for a qualified care provider,” Becker emphasizes, “So you want to keep good records of what you’ve paid and who you’ve paid it to, so that if the question ever came up, you could show those records.”
How Much Can You Contribute to a Dependent Care Flexible Spending Account, And Are There Any Drawbacks?
The maximum pre-tax contribution allowed by the IRS per year is $5,000 per married couple filing jointly (or $2,500 if married and filing separately), although your employer can set a different lower amount if they want, Becker says. The max just can’t exceed $5,000. Which, considering the average American is paying double that each year per kid, is admittedly a little light. “Also, your contribution can’t exceed the income of the spouse who earns the least,” Becker adds, “So in order to set aside the full $5,000 each year, each parent must make at least that much.”
The big catch with DCFSAs is that they’re “use it or lose it.” Which means if you max out your account but only spend $3,750 on after-school babysitting this year, you forfeit the remaining $1,250. “Any money that’s left in the account at the end of the year typically gets lost,” Becker says, adding that, unlike Health FSAs, there are no rollovers. Again, considering the high cost of care these days, this isn’t a huge issue for most parents but it does mean participants need to be vigilant about calculating exactly how much money they intend to spend on care. Nobody wants to hand the government free money.
How am I Saving Money With a Dependent Care Flexible Spending Account? And How Much?
The idea behind Dependent Care Flexible Spending Accounts is that, because you’re contributing money pre-tax, you’re lowering your adjusted gross income (AGI) for the year and reducing your overall tax burden. So if you’re normally taxed on $135,000 of income, but you maxed out your spending account at $5,000, you’ll now be taxed on the $130,000. “Any money that you contribute is deductible for income purposes,” Becker says, “So if you contribute $1,000 to your Dependent Care Flexible Spending Account , then when it comes to tax time, you’re going to have $1,000 subtracted from your income. That money won’t be taxed.”
The amount of money you save depends entirely on your combined marginal federal and state tax rates. “Whatever your federal tax rate plus your state tax rate is, that’s your savings,” says Becker. “So if you’re in the new 22 percent federal tax bracket, and then you’re taxed 5 percent from your state, add those together and you can save 27 percent on every dollar you contribute to your DCFSA.” Which means that if you contributed the full $5,000, you would save $1,350 for the year. A person living in California who falls into the highest federal and state tax brackets, however, could legitimately see a marginal tax rate of 50 percent, in which case the spending account would save them $2,500. “The general rule of thumb is that the higher your income, the more you stand to benefit from using a DCFSA,” Becker says, “And the reason is that you’re going to be able to deduct a higher percentage of your expenses if you’re in a higher tax bracket.”
Fortunately, there’s this handy online calculator to help figure out how much you can save with a DCFSA base on your tax rates and total contribution.
DCFSA or Child or Dependent Care Credit?
Again, the higher your income and tax bracket, the more you stand to benefit from using a DCFSA. If your income falls below $43,000, however, you’re better off using just the Child or Dependent Care Credit, which offers a 20- to 35-percent deduction on up to $3,000 for one child ($6,000 if you have two or more kids) on qualifying child care expenses depending on your income. The DCTC is based on a sliding scale, which means lower incomes get a higher rate. If your AGI is below $15,000, you get the full 35 percent tax credit. As soon as your AGI tops $43,000, the credit drops to 20 percent and your savings max out at $1,200 for two kids, $600 for one. If you set up the DCFSA, however, says Becker, “Your deduction might be 30 or 40 or even 50 percent, depending on where you live and what your income is.”
Assuming you have two dependents, you can use a Dependent Care Flexible Spending Account and claim the Child and Dependent Care Credit, but the savings will offset ⏤ meaning the contributions you make to the DCFSA lower the amount of the credit you’re able to take. “Let’s say you have two kids, which means you potentially would be able to claim up to $6,000 toward the credit,” Becker says. “And if you maxed out your DCFSA, you would contribute $5,000. That means you’d only be able to use $1000 for the credit: $6,000 minus $5,000 leaves you with $1,000 left. So, yes, you can use both the deduction offsets some of the credit.” Still, he adds: “DCFSAs are great, if you can use them. They really are a discount on child care.”