Under the Radar Tax Break for Working Parents - The Dependent Care FSA

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Executive summary

Becoming a parent can feel like an explosion of responsibilities...and expenses. Now add the COVID-19 pandemic turning child care upside down. And, if your income is increasing, you're likely phasing out of the child tax credit. Here's a silver lining that could save you on taxes: The Dependent Care Flexible Savings Account (DC-FSA) tax planning strategy. The DC-FSA is a government tax break for working parents. 

Why now? The Dependent Care FSA tax strategy recently became 2x more powerful with law changes in 2021. It can now save you up to $3,500 each year on child and dependent care expenses. But...many employers haven’t proactively communicated this increase with employees.

We break down below:
(a) what a dependent care FSA is
(b) what's changed that's made this an even more valuable tax planning strategy
(c) how to check if you qualify for the higher tax break and optimize your taxes with this strategy

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Table of contents

Written by
Ami Shah

Ami Shah is the CEO of Steward, a personal finance tool helping mid-career professionals to make the most of their money by investing smarter and saving on taxes, with minimal time and effort.

She's a Certified Financial Planner®, Harvard Business School and Harvard College grad. She served as a wealth and asset management consultant at McKinsey & Company and as a white-glove wealth advisor to ultra high net worth families. Ami started Steward to bring the clear, structured, and evidence-based set of rules white-glove wealth advisors use with ultra high net worth clients, to more people beyond the 1%.

More about
Ami Shah

What's a dependent care flexible spending account (DC-FSA)?

Tax Planning Strategy: 
Alphabet-soup name hiding a multi-thousand dollar tax break for working parents.

Dependent-Care Focused:
Chunk of tax-free care spending for kids under 13, disabled spouses, or older parents in eldercare.

Offered through employers:
~ 40% of workers have access to a DC-FSA through their employers according to the Bureau of Labor Statistics.

How much could it save on taxes?

Up to $3,500 in 2021. The DC FSA offers you an upfront tax deduction (i.e., savings of ~20-40% - depending on your tax bracket) on dependent care expenses up to $10.5K in 2021. 
Not bad for the max ~1 hour of effort to get this set-up and going.

Why now? What's changed?

American Rescue Plan Act Increases Dependent Care FSA Contributions | KRS  CPAs™

Recent laws enabled employers to make this benefit even more attractive to working parents in 2 ways.

1) double the max contribution:
Instead of the normal $5,000-per-year limit on tax-free contributions, a family can sock away up to $10,500 in a dependent care FSA in 2021 without paying tax on the contributions. Why? The recent American Rescue Plan ($1.9 trillion stimulus package passed during COVID).

2) more flexible in 3 ways:
a. mid-year contributions allowed in 2021
(typically not allowed unless you get married or have a child mid-year), outside of your annual "open enrollment" period (typically in November).
b. temporarily rollovers allowed
on any unused funds in 2021 to 2022, loosening the typical "use it or lose it" requirements and giving you more time to spend the money.
c. access even if you quit
: you can now continue to access your FSA for the rest of the year, even if you leave your job. Which might be on the table for you, given nearly 40% of the workforce is considering changing employers, in what’s being called the COVID "Great Resignation"

Why is this big news?

First change in 35+ years:
This is the first time this tax break has become more generous since 1986 because Congress set it up
WITHOUT indexing it to inflation (womp!) 
requiring an Act of congress to increase the limit

Directly reduces one of families’ largest expenses
This new limit is more in line with the national average cost of childcare, which it turns out (wildly!) is roughly double the price of a year's tuition to an in-state public university. Clearly still room to expand this, since according to this 50-state survey by the Economic Policy institute, shows annual infant childcare costs can go as high as $17,00 in California and $24,000 in Washington D.C. (my hometown)...but a step in the right direction.

Does this strategy make sense for me?

Two items to check to see if this strategy would work for your family to save on taxes.

1) Check if your employer offers a DC-FSA.
~ 40% of workers have access to a DC-FSA through their employers according to the Bureau of Labor Statistics. DC-FSAs can be combined with a standard health care FSA or an Health Savings account (HSA). DC-FSAs do not impact HSA eligibility.

2) Check if you have eligible expenses.

What’s included:
Expenses involved in caring for a child under 13, or other eligible loved ones who aren't physically or mentally able to take care of themselves.
That includes: after-school programs, nannies for whom you pay taxes, au pairs, nursery school or pre-school, summer day camp.

What’s excluded:
Tutors, music lessons, language classes, kindergarten, non-work related babysitting, or sleep-away camp. See the federal government’s official list for the full details.

The Fine print:
- Receipts required:
It is important that you save receipts in case the IRS requests itemized receipts. 
- Use it or lose it:
Similar to health care FSAs, there's a "use it or lose it" rule on these accounts, so you'll lose any funds remaining in your account when the plan year ends. - Your employer might offer you a 2.5 month grace period, or up to $500 to be rolled over to next year's plan.
- Requires a contribution to use:
You can only use money from dependent care FSA account, after you make contributions from your paycheck.

 Dependent Care FSA Eligible Expenses

How do I take advantage and sign up?

1) Determine how much to contribute

You should choose the maximum of either
(a) the new $10,500 limit OR your company's limit, in case it's lower. Companies aren’t adopt the new higher 2021 limits or flexibility (womp!), but we’ve seen some employees effectively lobby for increases!
(b) your estimate of how much you spend on qualifying dependent care each year (see list of what’s included / excluded above).

2) Proactively reach out to HR before this opportunity expires December 2021.

Many companies have left employees in the dark on this updated perk. At Steward, we've found multiple employers (e.g., Visa, Carlyle, etc.) of our clients (working professionals in their late twenties - forties) haven't communicated to employees that they're eligible for a more generous tax break in 2021. So it’s definitely worth proactively asking your employer, about if (a) they offer a dependent care flexible savings account (FSA), and (b) what's the latest upper limit you can contribute, and (c) when you can enroll. 

Note: 2021 is an unusual year since you can likely make changes outside of open enrollment periods. Going forward, you'll typically need to enroll during your employer's open enrollment period (typically November through mid-December) and elect a contribution amount on your employee benefits site during that time To make life easier, we’ve shared below...

An email template to send to HR

Hi {HR Benefits Contact},
I was wondering if I'm eligible for a Dependent Care FSA, and if there was any way to make a mid-year Dependent Care FSA change given the stimulus bill passed earlier this year?

Background:
I've heard many FSA administrators are allowing mid-year FSA changes in 2021, since they are able to. Know this was buried in the Consolidated Appropriations Act, and didn't receive much attention because it wasn't that big a deal until the American Rescue Plan Act doubled the FSA contribution limit for the calendar year 2021.

Just cognizant that so far the increased FSA contribution limits are (so far) only for 2021, and would love to take advantage given child care is one of our most significant expenses!

Asks for your help:
1. Could you let me know what the upper contribution limit for the Dependent Care FSA is and help me up our contribution to that limit? I'd like to up our annual contribution to $10,500, or whatever maximum our organization is allowing.
2. Could you let me know if there are any deadlines for me to keep in mind, and if the extension to roll over funds into 2022 applies to me?
3. Also would love your guidance on how best to file our expenses so that we can use the Dependent Care FSA.

What happens after you sign up?

1. You will receive an FSA debit card that you can use to pay for eligible expenses. The same card will apply to a Health Care FSA, if you have that account too.
2. If you don't use the card, then after you have received and paid for services, you'll need to submit a claim form for reimbursement. Remember to save all receipts, which are required for reimbursement and validation of expenses
3. Each plan year, you can incur eligible expenses until March 15 of the following year, and you have 90 days to file your claims.

 FAQs:

Can I still do this if I already have a Health Savings Account?

You can have a dependent Care FSA at the same time as an Health Savings account. You're not running afoul of any double-dipping rules. We personally use both!

How does the dependent care FSA differ from a healthcare FSA and can I have both?

Yes, you can have both. These are similarly named (confusing!) but they deal with different expenses: Childcare and eldercare related expense vs. medical and health related expenses. The DC-FSA limit went up 2x in 2021, but the the health care FSA limit stayed constant.

Health Care vs. Dependent Care FSA
Healthcare FSA vs. Dependent Care FSA

Curious to learn more?

- DC FSA tax strategy covered in Kiplinger (Tax-Focused Newsletter)
- DC-FSA covered on CNBC
- The federal government’s official list of what expenses are eligible vs. not
- Personalizing this and other tax strategies for your family: Steward is a personalized to-do list for how, where and when to invest and save on taxes in plain-English, with minimal time and effort. Steward can personalize your recommendation on next steps for a dependent care FSA. Steward can also integrate this tax strategy with your broader financial picture. Give it a try here.

Written by

Ami Shah

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