Depending on the FSA, employees can use the funds in their flexible savings arrangements (FSAs) to cover the costs of daycare for their dependents. But that might not always be the best approach from an income tax perspective. Here’s what employees need to know about tax-advantaged options for covering daycare expenses.
What are the different kinds of FSAs?
The two most common types of FSAs are health care FSAs and dependent care flexible spending accounts (DCFSAs). If you make them available to employees, they would need to elect to participate in them during your open enrollment period for benefits.
Health care FSAs are employer-sponsored accounts that give employees the ability to contribute pre-tax dollars as payroll deductions. The pre-tax deductions reduce an employee’s taxable income and can be used for qualified medical expenses for them, their spouses, and their dependents.
For 2023, employees can contribute up to $3,050 to their health FSAs without incurring a penalty. Health FSA contributions generally are “use-it-or-lose-it;” meaning that, at the end of the plan year, employees forfeit any amounts not spent.
Dependent care FSAs, also known as dependent care assistance programs (DCAPs), are used by caregivers for qualified dependent care expenses. Employees can apply the funds to work-related care for specific dependents that makes it possible for them to go to or look for work. Qualified dependents are:
- Under 13 years of age (or 14 for certain plans) at the time of the care; and
- Physically or mentally incapable of self-care and live with the employee for more than half of the year.
- An adult who is physically or mentally incapable of self-care and lives with the employee for more than half of the year.
Refer to IRS Publication 503 for a full list of requirements for categorization as a qualified dependent.
DCFSAs are also funded by pre-tax funds, which reduces taxable income. The annual contribution limits for tax-free DCFSA as of 2023 are:
- $5,000 per year for single tax filers or married couples filing jointly and
- $2,500 for married couples filing separately, subject to restrictions based on earned income.
DCFSA funds can be used with debit cards, if provided, or employees can use those funds by end of the year if they submit receipts of eligible expenses for reimbursement. These funds don’t carry over to the next plan year, but employers can offer a grace period of up to 2.5 months to spend unused funds at year-end.
Do DCFSAs cover daycare expenses?
Yes. DCFSAs can be used to cover eligible dependent care expenses—including specific childcare costs like babysitting, nannies, au pairs, daycare, preschool, summer day camp, after-school care or after-school programs—that are work-related. “Work-related” means that the dependent care expenses enable you to go to, or search for, work.
For example, the cost of a babysitter or daycare provider who watches your child while you work is eligible, but the cost of the babysitter who watches your child while you go out to dinner after work is not eligible.
This also means that expenses for a qualifying child in nursery school or similar programs for children below kindergarten are eligible. Expenses for care before or after school for children in kindergarten or higher grades are also covered, depending on the age of the child.
What other expenses can be paid with a DCFSA?
DCFSA funds can be used for several other types of care, such as elder care or for the costs of care provided by a dependent care center (as long as the center satisfies all state and local eligibility regulations for such centers). The IRS defines a dependent care center, such as an adult daycare or childcare center, as “a place that provides care for more than six persons (other than those who live there) and receives a fee, payment, or grant for providing services for any of those persons.”
The funds also can be applied to:
- Fees paid to an agency to obtain the services of a care provider.
- Deposits to an agency or preschool (but not forfeited deposits—for example, if you decide to send your kid to a different preschool and lose the deposit).
- Application fees for care provider services.
- In-home services (such as a housekeeper, maid, or cook) if they at least partly provide for the well-being and protection of a qualifying dependent.
On the other hand, expenses for education (including summer school and tutoring) aren’t for work-related care. Neither are the costs of sending children to overnight camp. A day camp, however, might be work-related, even if it’s a “specialty camp” (for example, for computers or a particular sport) if you go to or search for work while the dependent is at camp.
Be sure to check with your tax advisor or FSA administrator if you have questions about whether a certain expense is eligible to be covered under a DCFSA.
Which is better for daycare expenses—the child and dependent care tax credit or DCFSA funds?
DCFSAs are only one way to reap tax benefits from childcare expenses. Employees also may qualify for the child and dependent care tax credit. This credit allows for a percentage of dependent care that you incur that is work-related to be given to your taxes.
The credit generally is available for the same care as DCFSA funds. But there’s a catch—you can’t double-dip by claiming the credit for dependent care services you paid with DCFSA funds. So which is the better deal?
The tax credit generally is available for up to $3,000 annually in care expenses for one child or dependent and $6,000 annually for two or more. The maximum annual credit is 35 percent of the expenses (so $1,050 for one child or dependent and $2,100 for more).
The credit percentage begins to drop when adjusted gross income (AGI) exceeds $15,000. When the AGI exceeds $43,000, the maximum credit is 20% of qualified expenses ($600 for a single child and $1,200 for more).
The DCFSA option generally produces more bang for the buck for employees during tax return time, especially those with one child. These employees can contribute FSA funds (and reduce their taxable income by) up to $5,000 for care expenses but claim a maximum credit of only $2,100.
Employees with more children, though, can maximize their tax benefit by using both vehicles. They can contribute $5,000 to a DCFSA for their first $5,000 in expenses and claim the applicable percentage credit on up to $1,000 in additional eligible expenses (the $6,000 maximum allowable expenses less the $5,000 DCFSA contributions excluded from income).
There were different rules a few years ago
The American Rescue Plan Act made the child and dependent care tax credit more beneficial than usual for a limited period. In 2021, individuals could claim a fully refundable 50 percent credit of up to $8,000 in care expenses for one child or dependent and up to $16,000 in expenses for two or more children or dependents. In other words, it was worth up to $4,000 for one child or dependent or $8,000 for more.
The 50 percent credit started phasing out when household adjusted gross income (AGI) exceeded $125,000. It phased out completely when AGI was more than $438,000. (The child and dependent care credit typically didn’t drop below 20 percent, regardless of income.)
This temporary expansion significantly changed the variables at play when trying to chart the most tax advantageous course. Relevant factors included the taxpayer’s AGI, number of children and dependents, expected care expenses—and whether employers chose to boost the DCFSA contribution limit for the year. Some employers chose not to, particularly in light of the expanded tax credit.
In addition, while the 2020 COVID relief bill granted temporary, optional exceptions and changes to DCFSAs in 2021 and 2022, Gusto didn’t support the following amendments:
- Employers can extend the grace period to 12 months after the end of the plan year for the 2021 plan year.
- The American Rescue Plan Act of 2021 increased the annual DCFSA contribution limit from $5,000 ($2,500 for married individuals filing separately) to $10,500 ($5,250 for married individuals filing separately).