Want to Offer a Dependent Care FSA to Employees? Some May Owe More Tax by Contributing

The Basics of Dependent Care FSAs

• Among the many tax-advantaged benefits employers may offer their employees is a dependent care flexible spending account (FSA) under Internal Revenue Code Section 129.
• A dependent care FSA allows employees to pay for dependent care on a pre-tax basis.
• In 2024, single filers and married couples filing jointly can contribute up to $5,000 to a dependent care FSA. (The contribution limit is $2,500 for married filers filing separately.)
• Employees elect how much to contribute at the beginning of each year and unused amounts may not be carried forward to future years.

Tax Savings of Dependent Care FSAs

• The tax savings offered by a dependent care FSA can be substantial.
• For example, a family might save $600 in tax as follows:
  • The Barkers are a married couple filing jointly with two children.
  • They pay $5,000 per year, per child, in qualifying childcare expenses.
  • They have $80,000 in taxable income and therefore a 2024 marginal federal income tax rate of 12%.
  • If the Barkers contribute the maximum $5,000 to a dependent care FSA, they will pay $5,000 of their childcare expenses with pre-tax instead of post-tax dollars. This would save them $600 (0.12 marginal tax rate x $5,000 income exclusion).

Unintended Tax Consequences of Dependent Care FSAs

• While the tax savings offered by a dependent care FSA are appealing, they come with a potential trap for the unwary: reduced eligibility for the dependent care tax credit under Internal Revenue Code Section 21.
• Taxpayers can owe more taxes by contributing to a dependent care FSA than they would have otherwise owed.
• This odd result follows from the basics of the dependent care credit under Section 21:
  • The credit is calculated as a percentage of qualifying expenses for household services or dependent care.
  • Qualifying expenses are capped at $3,000 for one dependent and $6,000 for two or more dependents. But this cap is reduced by the amount contributed to a dependent care FSA.
  • The maximum percentage of qualifying expenses that can be credited is 20% for taxpayers whose adjusted gross income is over $43,000.
• As a result of these rules, the family from our previous example might owe $400 more in taxes by contributing to a dependent care FSA:
  • The Barkers pay $10,000 in total childcare expenses. This means that they would ordinarily be entitled to a dependent care credit of $1,200 (0.2 credit percentage x $6,000 maximum allowable expenses).
  • But here is the catch: The cap on qualifying expenses for the dependent care credit (which would otherwise be $6,000 for the Barkers) is reduced by their $5,000 contribution to a dependent care FSA.
  • This means that only $1,000 of the Barkers’ childcare expenses qualify for the dependent care credit, leaving them with a reduced credit of only $200 (0.2 credit percentage x $1,000 maximum allowable expenses post-reduction).
• Overall, then, by contributing to the dependent care FSA, the Barkers save $600 (from the dependent care FSA) plus another $200 (from the dependent care credit) for a total of $800.
• This is significantly less than the $1,200 they would have saved had they not participated in a dependent care FSA, because the dependent care FSA benefits came at the cost of full eligibility for the dependent care credit.

Implications

• Like all benefits decisions, the decision to offer a dependent care FSA depends in large part on the demographics of one’s workforce.
• Taxpayers who earn more than the Barkers in our example might benefit from contributing to a dependent care FSA despite the resulting reduction in their dependent care credit.
• Ultimately, benefits departments should work carefully with their advisors and plan participants to ensure that the programs they implement meet their intended objectives – it would be a shame to spend time and money on a tax-savings program that ends up costing employees more than it saves them.