The Dependent Care FSA and the Dependent Care Tax Credit are widely used benefits throughout the country. It's an account that allows a person to contribute pre-tax dollars to and subsequently withdraw from, for dependent care expenses (i.e. daycare) that have been incurred due to you having to be at work. There is also another benefit afforded to individuals who find themselves in this similar situation and that is the dependent care credit. These are two different tax advantaged ways of helping with the affordability of dependent care expenses. Families have always had the option of choosing one over the other or a combination of the two. Thanks to the American Rescue Plan of 2021, you may want to re-think the way you are using each of these benefits in order to maximize their total economic benefit.
- The benefits of using a dependent care FSA account
- 2021 FSA contribution limit changes
- The benefits of the dependent care credit
- Which should you use. FSA or Tax Credit?
- Social Security Income Tax Threshold
Before you begin, check-out our complementary checklist on things to consider when you start a new job (like an FSA). What-Issues-Should-I-Consider-When-Starting-A-New-Job-2021.pdf
Do you prefer video over the written word? That's ok, we've got you covered! Take a peak at our YouTube video that covers Dependent Care FSAs and Dependent Care Credits!
What is the benefit of a dependent care FSA?
A dependent care FSA account allows you to shield some of your gross income from federal, state, and payroll (FICA) taxes. Before withholdings for these taxes are taken from your paycheck each pay period, you get to take a portion of your income and put it into an FSA account. This could mean significant tax savings for anyone who finds themselves earning a six figure income.
Let's assume that Harvey is a pharmacist and is married. Let's also assume that he finds himself in the 22% marginal tax bracket for Federal taxes, 6% for state taxes, and pays 7.65% in payroll tax (6.2% for Social Security and 1.45% for Medicare). If Harvey and his spouse earn $170,000 in a year and he contributes the traditional max of $5,000 into his FSA, he is looking at a tax savings of $1,782.50. That $5,000 he contributed to his FSA (assuming he has that much in childcare expenses in the year) would avoid the 35.65% combined total of federal, state, and payroll tax. ($5,000 x 35.65% = $1,782.50).
2021 Changes to the FSA Contribution Limit
Due to the passing of the American Rescue Plan (ARP) of 2021, the maximum amount of what you are allowed to contribute to a dependent care FSA has more than doubled. Before, the max was $5,000/year. The ARP has increased that limit to $10,500. This is significant for any households who find themselves paying that much or more in qualifying child care expenses.
Let's use Harvey as our example again. Same information as before except that he decides he wants to contribute $10,500 to his FSA instead of the $5,000. He and his spouse have child care expenses that exceed this amount so they are going to have no problem qualifying to use the higher contribution amount in 2021. Now instead of only $5,000 of Harvey's gross pay being able to avoid the 35.65% of taxes, he will now shield $10,500. Which means that increasing his FSA contribution too $10,500 will save him a total of $3,743.25. About $1,960 more in tax savings for child expenses he is going to have to pay anyway! It seems like a no brainer decision.
The other important caveat to note is that the ARP of 2021 gives employers the flexibility to allow their employees to increase or decrease their FSA annual contribution amounts during the plan year. Before this wasn't an option. But it's dependent on the employer allowing it. Some employers will and some other will not. You'll have to ask to find out.
What are the benefits of the Dependent Care Credit?
First, to be able to receive a dependent care credit on this years taxes, you will have to qualify. Use this resource from the IRS to learn more here. Let's assume you meet all the testing requirements. How does this credit work? It's important to know that this credit is a monetary way to provide help to anyone who is looking to be gainfully employed. Thank you Uncle Sam! The best way for Uncle Sam to provide you with a meaningful monetary benefit is through a tax credit. After all, a tax credit is a dollar for dollar decrease in the amount of tax that you owe at the end of the year.
So the credit works like this. The first piece of this puzzle is determining how much of your annual dependent care expenses can be used toward the tax credit formula. The IRS is friendly, but not that friendly. If you have $50,000 of daycare expenses (lucky kid(s)), the IRS is not going to allow you to use all of those expenses when determining how much of a credit you'll get. Instead they have capped it at two different levels. Those levels are determined by how many dependents you have. For example, in 2021 if you have one child you can use up to $8,000 of child care expenses in the tax credit formula (we'll get to that shortly). If you have 2 or more children, you can use up to $16,000 of child care expenses. These limits were significantly increased thanks to the ARP of 2021.
The credit formula works like this. You take your total maximum expense amount allowed (depending on how many kids you have) or your actual total amount of care expenses incurred that year. Whichever is SMALLER.
Ex: Harvey has 2 kids. He anticipates spending $20,000 in the year for daycare expenses for his two kids. Because he has two kids he is allowed to use up to $16,000 of those expenses in the formula to determine how big his credit is going to be. $16,000 is less than $20,000. If Harvey only anticipated spending $10,000 on daycare expenses, he would use $10,000 instead of $16,000. $10,000 is less than $16,000.
Now that we've determined the total amount of allowable expenses that can be used in the formula, we move on to the next step. The next step is determining what percentage of the allowable expense amount ($16,000) can be used. That percentage factor is dependent on what your Adjusted Gross Income is. The IRS does not want to reward a household that earns $400,000/year with the same amount of credit as a household that earns $60,000/year, even if they spent the same amount on daycare expenses. To do this, they apply a percentage to you, based on your Adjusted Gross Income, that you multiple with your starting allowable expense amount. The AGI and percentage trade-off is listed in the table below. It's important to note that this phaseout table applies regardless of filing status.
Household Adjusted Gross Income
$0.00 - $125,000
$125,000 - $184,999
|Reduce the 50% applied percentage by 1% for every $2,000 of AGI the taxpayer is over $125,000|
$185,000 - $399,999
$400,000 - $439,999
|Reduce the 20% applied percentage by 1% for every $2,000 of AGI the taxpayer is over $400,000 all the way to 0%|
Let's frame this within the context of our example.
Harvey and his spouse have two kids. They have an Adjusted Gross Income of $170,000. Their maximum allowable amount of expenses they can use to determine their credit is $16,000. Using the table above we can see that the applied percentage they can use to determine their tax credit is 27.5%. ($170,000 - $125,000 = $45,000. 1% decrease for every $2,000 over = 22.5%. 50% - 22.5% = 27.5%)
We will then multiple Harvey's allowable expense amount ($16,000) by his applied percentage (27.5%) and we get $4,400. This $4,400 would be the allowable tax credit afforded to Harvey and his family in 2021.
Dependent Care FSA and/or Dependent Care Credit
Up to this point you may be thinking "Great! Harvey will save $3,743 in taxes by using his FSA and another $4,400 in tax credits." Not so fast. You are not allowed to apply the same daycare expenses to FSA contributions and tax credits. No double dipping! You can use both the FSA and receive a tax credit, but only if your actual daycare expenses are high enough.
|# of Kid(s)||FSA Max||Allow Expense Max for the Tax Credit||High Of|
This table lays out the maximum amount of daycare expense you will qualify for, for tax savings purposes, depending on how many kids you have. If you have 1 kid, you can use up to $10,500 of daycare expenses. Meaning you can max out your FSA at $10,500, max out your credit amount at $8,000, or a combination of the two up to the cap of $10,500. If you have 2+ kids, you can max your FSA at $10,500, max out your credit amount at $16,000, or a combination of the two up to a cap of $16,000.
So which option has the most economic benefit to you? It all depends on a number of different factors. Those most important being number of qualifying dependents, income, and total daycare expenses. Let's take a look at Harvey again.
We know that the maximum amount he can use to apply toward an FSA and/or toward the dependent care credit is $16,000 because he has 2 kids. We also know that if he applies that $16,000 all toward the credit (assuming he has made no FSA contributions up to this point) he would earn a $4,400 credit. However, if he were to max-out his FSA at $10,500, he would still have $5,500 of eligible expenses left over of the $16,000 he is allowed to use. Putting $10,500 into an FSA would save him $3,743 in taxes. He could than use the $5,500 he has left over to apply toward the credit. $5,500 x 27.5% (his applied percentage) = $1,512.5. That means the combined total of this option would provide him with a total economic benefit of $5,255.
So at Harvey's income level and having 2 dependent kids, it would be in his best interest to max his FSA and use the remaining allowable daycare expenses ($5,500) to be applied toward the credit. And this makes sense. Harvey is saving 35.65% on taxes with each dollar his contributes to his FSA. He is only getting a 27.5% for a credit on any allowable daycare expenses he has. 35.65% is larger than 27.5% so it would lead to Harvey wanting to max out his FSA instead of trying to max out the credit he gets at the end of the year.
Let's assume that Harvey is a stay at home dad and his wife, Donna, is an ambulatory pharmacist earning $135,000/year. They still have two dependent kids and anticipate spending $20,000 on daycare expenses. Keeping everything else the same, let's see how it shakes out.
First lets assume that they decide they want to max out the increased FSA contribution amount. They shield $10,500 from federal, state, and payroll tax by contributing that much to their FSA. The same total tax savings rate is 35.65%, which is $3.743 in hard dollar savings. Nothing has changed. They use the remaining $5,500 (because they have two kids, the max amount of daycare expenses they can use is $16,000). Because their income is lower ($135,000 & not $170,000) their applied percentage for the tax credit goes up to 45%. That applied percentage of 45% multiplied by the $5,500 of remaining actual daycare expenses gives us a credit of $2,475. The total economic benefit in this scenario is $6,218 ($3,743 FSA benefit + $2,475 tax credit).
The other option is to forgo any FSA contributions and apply all benefit toward the credit amount. They take their $16,000 of allowable expenses, because none of that $16,000 is going toward FSA contributions, and multiple it by their applied percentage which is 45%. Their total credit amount will be $7,200. Their total economic benefit will be $7,200 because they received no tax savings because they didn't contribute anything to an FSA. In the end, because of their income level, they will end out getting almost an extra $2,000 by NOT making any FSA contributions in this scenario compared to maxing out their FSA.
But lets be real. The American Rescue Plan went into affect after most people decided to already start contributing to an FSA when they thought the max amount was $5,000/year. So lets play off that scenario.
Again, Harvey is a stay at home dad. Donna makes $135,000/year. Their daycare expenses are $20,000. Donna has already contributed $2,500 to her FSA up to this point. She is trying to decide which is better. Increase her FSA contribution to take advantage of the higher limits or try and earn more economic benefit through the credit.
At that income level and with 2 kids, her FSA economic benefit is 35.65%. Her credit applied percentage is 45%. Any additional dollar she contributes toward her FSA would be a net loss of 9.35%!
What if Harvey hates being a stay at home dad and decides to get a job half way through the year. He anticipates making $25,000. Their total household income goes up to $160,000. Their FSA benefit of 35.65% stays the same. However their applied percentage of the tax credit now goes down to 32.5%. Meaning, now every extra dollar of FSA contribution nets them a gain of 3.15%.
A change in income of $25,000 has completely changed the strategy of which option to pursue. This can make it really tough for families to decide what to do if their income is uncertain. However, if families do have a good idea of what their household income will be at the end of the year, they can do some real planning and hopefully save themselves some money.
We've talked a lot about taxes so far. If you want to learn more, check-out the PharmD Money Podcast Ep 13: Deciphering The Greatest Puzzle Of All Time. Tax Code.
Social Security Income Tax Threshold
Another factor that should be considered in regards to the FSA contribution limits is that the larger 2021 $10,500 contribution limit is per household. Meaning that if both spouses have the option of contributing to an FSA, they can't contribute more than $10,500 in total between the two of them.
This is important if one spouse earns more than the social security income tax threshold. The social security income tax threshold is the income amount that if any individual surpasses, does not have to pay their 6.2% social security payroll tax on any dollar earned after that point. In 2021, that amount is $142,800.
Let's assume you are a tenured nuclear pharmacist earning $157,000/year. Each dollar you earn after $142,800 will not have the added 6.2% social security tax withheld from your paycheck. This is important because any FSA contribution at this point isn't providing the same tax savings as someone who earns under that limit. Earnings above that limit will only allow you to avoid federal, state, and the Medicare portion of the payroll tax on any FSA contributions.
Ex: Harvey earns $40,000/year. His wife Donna earns $157,000. Because of their high income, they are better off maxing out their FSA. Both Harvey and Donna have the ability to contribute to an FSA. It would be in their best interest if Harvey made all of the FSA contributions. Any contribution to his FSA would shield that money from Federal, State, and full Payroll Tax (Social Security at 6.2% & Medicare at 1.45%). If Donna contributed to her FSA, she would only get the benefit of that contribution being shielded from Federal, State, & the Medicare portion (1.45%) of the payroll tax.
So by Harvey making all the FSA contributions, their total tax savings using this strategy would be $651 alone!
There are so many variables involved in determining which is the best option for you. If you have over $16,000 in daycare expenses and your adjusted gross income is over $153,700, chances are you will benefit from increasing your FSA contribution to the max if you have that much in daycare expenses. That is also assuming you are getting taxed at 35.65%. If you have a household income of under $153,700, have two kids, you may be better of stopping any FSA contributions and allowing yourself to apply more of those allowed expenses toward the tax credit.
If you have one child, the equation changes dramatically. Regardless, do your best at trying to figure out which option or combination of the two works best for you. Also remember that things may look very different in 2022. So don't forget to re-set your FSA and Credit planning for next year as well!