Personal Finance 

How Dependent Care FSAs Work

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We have some friends that have been looking at day care centers in the area and it’s mind boggling how expensive child care can be, at first glance. It’s no surprise when people say that it’s often not even worth it to be working if you have to put two or more kids into daycare. One particular school charges about $1500 a month, which is more than what I paid in rent the first few years I lived in Maryland!

Fortunately, there are a few tax credits and employer benefits that can mitigate some of those costs. One of those employer benefits is a dependent care FSA. Dependent care FSAs are designed to allow you or your spouse to continue working while supporting a dependent, which is typically going to be a child (but doesn’t have to be). To that end, a dependent care FSA lets you contribute part of your pre-tax salary into a special account to help pay for those costs.

Qualifying Dependents

A qualifying dependent has to qualify one of these three conditions:

  • Be a tax dependent under the age of 13,
  • Any other tax dependent who is physically or mentally incapable of self-care and resides in the same principle residence,
  • A spouse who is physically or mentally incapable of self-care and has the same principle residence.

Contribution Limits

The federal limit is $5,000 per year per household, lowered to $2,500 for those married filing separately. If both spouses work and both of their employers offer this, their total combined FSA balances cannot exceed the $5,000 federal limit. If one spouse does not work, he or she must be disabled or a full-time student or the household loses access to the dependent care FSA (remember, the purpose of this is to allow someone to continue working while supporting their dependents). If either spouse earns less than $2,500 a year, then the limit is lowered to the level of that spouse’s salary.

Don’t forget about the Child and Dependent Care Credit when you are deciding how much to contribute. That credit is worth $3,000 of expenses paid in a year for one qualifying individual and $6,000 for two or more. That credit’s amount is lwoered by any benefit provided by your employer.

Which Expenses are Eligible?

Your employer should provide a list of expenses that are and are not eligible but in general expenses related to providing care are eligible, with the exception of “food, lodging, clothing, education and entertainment.” The IRS does allow you to include “small amounts paid for these items if they are incident to and cannot be separated from the cost of caring for the qualifying person.” The IRS also states that, at least for education, expenses for nursery school, pre-school and similar programs for children below the level of kindergarten are considered expenses for care. Kindergarten or higher are not (though before and after school programs may be). Things start to get really complicated after a while so I recommend reading Publication 503: Child and Dependent Care Expenses and contacting your HR for more information.

How They Differ from Medical FSAs

There are a few quirks that make Dependent Care FSAs slightly different than medical FSAs (other than the contribution limit). The biggest difference is that you can’t spend funds unless they’ve already been contributed. For example, if you elect $100 a month ($1200 a year), then you won’t be able to spend the first $100 until after you’ve made the contribution through payroll. Medical FSAs are prefunded, meaning you would have access to the entire $1200 before having the payroll deductions.

I’ll be honest, I thought it was going to be a pretty easy post when I started writing it but it really got complicated pretty quickly (especially after I read about the $3,000/$6,000 tax credit), since the Medical FSA is fairly cut and dry. I hope my explanation of Dependent Care FSAs was clear! 🙂

{ 19 comments, please add your thoughts now! }

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19 Responses to “How Dependent Care FSAs Work”

  1. mannymacho says:

    I don’t see how a day care center can justify charging $1500 a month. At that point, you can pretty much get a full-time nanny,

    • Jim says:

      It’s all about where you live, nanny’s here are probably around $1800/mo or more.

      • Tracy says:

        Hi Jim, you’re right, it is complicated! I think I’m going to have to consult with an accountant to figure out the best scenario for our own family. I’m also confused how it works with preschools that are also daycares.

        High quality day care is expensive, I pay more for it during the summer than my mortgage, car payment and insurance combined! On the other hand, I can see how and why they charge so much between salaries, facilities/overhead and insurance.

    • cubiclegeoff says:

      $1500 a month where I live is a relatively basic amount for a standard day care (like kindercare). But if you have multiple children, going the nanny route can be cheaper. Or some people get together and hire a nanny for several children.

      I use the dependent care FSA, and it’s just unfortunate that you have to wait for the money to build before you can get reimbursed.

  2. If you’re self-employed, can you set up this type of account for your own family?

    • Jim says:

      I’m afraid I don’t know, but I don’t see why not. You just need to work with a health care provide that offers this I guess?

    • Scott says:

      I personally would guess no, simply because money not used in your FSA at the end of the year is kept by your employer, which in this case would be yourself, and that seems like a pretty big loophole they would have closed already.

  3. Courtney says:

    So, I don’t have kids yet, but I’ll probably have to deal with this at some point. I don’t understand how the DC-FSA and the Child Care Credit interact. If someone is paying enough in child care, can they use both?

    Using your $1500/month figure, that’s an expense of $18000 per year for one child. So could hypothetical-mom-me put the first $5000 into my DC-FSA (for a federal tax savings of $1250) and then claim the credit for my next $3000 (a $600 tax savings)?

    • cubiclegeoff says:

      For one child, you either take the credit or use the FSA. For 2 children, you can use the FSA, and subtract that amount from the credit (so if you put in $5,000 into the FSA, and are eligible for a $6,000 credit, you subtract the $5,000 and you can only take $1,000 as a credit). At least that is my understanding.

  4. Aaron says:

    I’m having trouble understanding the relation between the Dependent Care FSA and the Child and Dependent Care Credit. Last year I contributed the max amount of $5000 of the Dependent Care FSA because I live in the same area as Jim (NOVA 4 Life). When I filed our 2010 Taxes I expected to get a nice fat $3000 Child and Dependent Care Credit. Ol’ Turbo Tax put the kibosh on that and I recall it was because of the DP FSA. Turbo Tax said that I qualified for $0 in credit.

    • Courtney says:

      Well it wouldn’t have been a $3000 credit anyways – it’s a 20-35% (depending on your income) credit of up to $3000 in expenses for one child. The most credit you could ever get is $2100 (2 or more children, $6000 in expenses on an AGI of $15K or less.

      But it sounds like you answered my question above and it’s an either/or (DC-FSA or credit) and not both.

      • Aaron says:

        I guess I was confused about something else. I remember my parents wanted to claim me as a dependent for as long as they could to get some mythical $3000 credit. I always thought that parents get a straight up $3000 credit for their dependents. Of course I never looked into it so I can’t really be disappointed in something I know nothing about.

    • Heather Webb says:

      To Aaron whatever you decide to have taken out of your paycheck for the dependent FSA is limited to the 5000. The amount you choose for the year once you surpass that, you are able to claim the childcredit up to 3000/child and 6000 for two children. Note: if you pay an individuall person you have to name that person and their tax id # or SSN. Like they said earlier if you are married the dependent FSA is reduced. SN: They really do charge too much for childcare for single parents (such as myself) and married couples. It’s really cheaper to not work at all. Even though that’s not what people want to do and have to rely on the government.

  5. Scott says:

    Two additional points I investigated recently while dealing with all of this:

    1 – Unlike medical FSAs there is typically never a grace period into the next year (depends on your employer but this is almost always the case). You must spend the money in the current calendar year or you lose it.

    2 – I don’t think there’s anything that states dependent care FSA money must be spent on YOUR child (unlike the dependent care credit which I think does require it). I think you could potentially spend unused money at the end of the year on someone else’s childcare. But someone would need to double check this.

    • Tracy says:

      In response to no. 2, I don’t think you could use it to pay for someone else’s child. When you fill out your benefit papers, you have to supply the child’s name and dob. When you file for reimbursement you have to include this info with either a signature from the provider or a receipt reflecting the service/service period.

      You have to include the tax id of the provider.
      You have to make sure that your receipt accurately reflects the time period that the service is provided.

      The biggest issue that I have with them is that you have to be careful how you file it. If you pay by the month, and you count on this money to help you pay next months fees, you will need to possibly have the day care provider print the receipt on a weekly basis, that way you can file by the week, otherwise they will not process your claim until the end of the month (big gotcha for me, FSA company is not allowed to process/pay until the services have been rendered)…which means that that is you have to wait until Jan 31st for them to process it, you likely will not get your money until mid Feb. and you will have already had to pay out Feb daycare expenses….

      Sorry for the long explanations.

  6. skylog says:

    as someone who does not have children, all i can say is wow. that is a lot of bank. i understand the law of supply and demand, but jeez, that is just unreal.

  7. I’m curious about the limits. My partner and I fall into the category of single-income families with one (actually both) of us being full-time students. Your article (and almost all I have read) indicated that the maximum benefit is tied to the smallest income,

    “If either spouse earns less than $2,500 a year, then the limit is lowered to the level of that spouse’s salary.”

    but I’m curious how this works if you are a single-income family with a full-time student?

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