Dependent Care Flexible Spending Accounts
This letter explains the advantages of using a dependent
care flexible spending account (FSA), for qualified child care costs. In general, the FSA is probably more
advantageous than the credit, however, it is important to calculate a
comparison of the two alternatives to ensure and confirm the best result. There are also non tax considerations in
deciding how best to use your FSA option with your employer.
The requirements for expenses which qualify for a dependent
care flexible spending account are the same as for the dependent care
credit. In general, you must maintain a
home which you live in with your child or other qualified dependent, the
expenses must be incurred to enable you and your spouse to work, must be for
the care of a qualified dependent, and you and your spouse must both have
earned income during the year. The
payments must be to someone other than someone who could be claimed as a
dependent on your tax return, and you must file a joint return for the year.
Typical expenses that qualify for the program include day
care, nursery school, in home care by your domestic employees, (including
related payroll taxes), and after school care for a child under the age of 13,
or unable to care for themselves. Expenses
for "day camps" during the summer and school holidays should qualify,
but overnight camps do not.
The advantage of the dependent care credit is that it
reduces your income tax dollar for dollar.
However, this benefit can be markedly smaller than that of the flexible
spending program. The maximum benefit
under the dependent care credit can be summarized in the following table based
on your adjusted gross income (AGI).
AGI Not
Applicable One Two or
Over Percentage Individual More
$10,000
30% $720 $1440
12,000 29% 696
1392
14,000 28% 672
1344
16,000 27% 648
1296
18,000 26% 624
1248
20,000 25% 600
1200
22,000 24% 576 1152
24,000 23% 552
1104
26,000 22% 528
1056
28,000 21% 504
1008
20% 480 960
The credit cannot be lower than 20% of qualified
expenses. Accordingly, taxpayers whose
AGI exceeds $28,000 will have a maximum credit of $480 for one child and $960
for two or more children.
The benefit derived from a dependent care flexible spending
program is calculated based on an amount of wages which is excluded from
income. Accordingly, this amount will
reduce your taxable income and therefore your tax. The benefit can be quantified most simply by reference to your
marginal income tax rate.
For example, if you are in the 28% marginal federal tax
bracket, have two kids in day care, and you defer the maximum of $5,000 to the
flexible spending account, and in fact spend the $5,000 on qualified care, your
benefit is $1,400, ($5,000 x .28). This
compares with the maximum $960 tax reduction from utilizing the credit.
Additional savings are derived from the possible reduction
in social security taxes and state income taxes. If you are within the base amount for social security taxes,
further savings of 7.45% results from the exclusion of these wages. As a resident of the state of ________, an
additional savings of ______________ is possible.
Of course there are restrictions on the use of the FSA
arrangement to consider. Mechanically,
once your election is made to participate for the year, amounts are withheld
from your paycheck. This election is
not easily changed. You must then
submit appropriate receipts and other documentation for reimbursement. This delay in cash flow must be considered.
Finally, amounts deferred, or deposited into an FSA which are not used for
qualified expenses are forfeited.
I will contact you next week to discuss this option with you further. I would be happy to run a comparative calculation to assist you in determining if an FSA makes sense for you and your family. We can also discuss the possible health care dimension of your employer's FSA program as well. Of course, please call with any questions you may have with respect to this or any other matter.