Child and dependent care is a critical issue and a large expense for many American families. Millions of people rely on child care to be able to work, while others are responsible for older parents or disabled family members. If you care for a child or adult who is incapable of self-care, who lives in your home for at least eight hours each and whom you can claim as a dependent on your income taxes, you may be able to take advantage of dependent care flexible spending accounts (FSAs). These accounts allow individuals to pay for qualified child and dependent care expenses while lowering their taxable income. (For related reading, see Give Your Taxes Some Credit.)
Dependent Care FSA Overview
Dependent care FSAs are set up through your workplace. Participants authorize their employers to withhold a specified amount from their paychecks each pay period and deposit the money in an account. Instead of using the FSA money to pay for expenses directly, you pay those costs out-of-pocket and then apply for reimbursement.
Once you have paid for expenses that qualify for reimbursement from the FSA you will need to complete a claim form provided by your employer and attach receipts or proof of payment with the form. The receipts must include specific information to prove that the payment was for qualified expenses. Specifically, the receipt must note:
- the date of the expense incurred
- the expense amount
- the full name, address and social security number (SSN) or tax identification of the person who provided the care
The main benefit of an FSA is that the money set aside in the account is pretax, thus reducing the amount of our income subject to taxes. For someone in the 28% federal tax bracket, this income reduction means saving $280 in federal taxes for every $1,000 spent on dependent care with an FSA.
Benefits of a Dependent Care FSA
The IRS limits the total amount of money you can contribute to a dependent care to $5,000 each year for married couples filing jointly, unmarried couples and single individuals and $2,500 if you are married and filing separately.
If you and your spouse are divorced, only the parent who has custody of the child(ren) can use FSA funds for child care. If you are married both you and your spouse must work and earn income to qualify for reimbursement (unless one spouse is disabled and unable to work). If not, the money you contribute to the account will be forfeited and you will be billed for the taxes due because you did not pay taxes on the amount in the first place.
The money in your FSA can only be used for expenses for:
- A dependent who is younger than 13
- A spouse who is unable to work and care for him or herself
- Another adult dependent who is unable to care for him or herself and for whom you claim the dependent exemption on your taxes
Expenses That Qualify for FSA Reimbursement
Once you deposit money into an FSA, you can begin using those funds toward reimbursement for qualified expenses. You can only use the money for bills that meet the IRS definition of eligible dependent care service. That means that the services must be necessary in order for you and/or your spouse to work and earn an income. Qualified expenses include:
- Physical care
- In-home care, such as a nanny or au pair, or institutional-setting care, such as child or adult daycare services, by qualified caregivers
- Summer day camps
- Before- and after-school care
- Transportation provided by a caregiver
- Application fees, deposits, etc. required for obtaining care, but only if care is subsequently provided
The IRS' Publication 503: Child and Dependent Care Expenses outlines expenses that qualify for FSA reimbursement.
Expenses That Do Not Qualify for FSA Spending
Remember that you can only use FSA money for expenses that are necessary for you and/or your spouse to work and earn an income. Expenses that do not qualify as FSA-approved and therefore are ineligible in an FSA include:
- Education (i.e. kindergarten, summer school, tutoring, school tuition)
- Babysitting by minor-age (under 19) sibling/child or individual claimed as a dependent
- Overnight camps
- Enrichment programs and lessons (i.e. music, sports lessons)
- Custodial nursing care or long-term care for parents not living with you
What to Consider
Before creating a dependent care FSA, you should consider the following:
- FSAs are not "prefunded." With some healthcare FSAs, the employer "fronts" the money and is repaid through paycheck withholding. With dependent care FSAs, you pay expenses out-of-pocket, then receive reimbursement based on how much you have withheld from your paycheck for dependent care expenses.
- Before setting up a dependent care FSA, compare its potential tax benefits with the child and dependent care tax credit.
- FSAs operate with a "use it or lose it" policy, meaning that you must use all of the money you deposited into the account for qualified expenses by the end of the plan year or you will lose your money.
- You will need to report your FSA contributions on your federal tax return.
- Participation in a dependent care FSA is not automatic - you must re-enroll every year by the enrollment deadline.
- You can only change the amount of money you choose to have withheld from your paycheck for the FSA within a 31-day window following a "qualifying event", such as a marriage, the birth or adoption of a child, the death of a dependent, divorce or a change in your (or your spouse's) employment.
Opening and funding a dependent care FSA can help you plan and pay for the care you need to help you be able to work and earn a living. Consider looking into a plan offered by your or your spouse's employer and learn about how much you could save on taxes by taking advantage of this option.