Childcare costs and the dependent care FSA

In short

A friend of mine spent a whole summer paying for day camp out of his checking account. He never once asked if the tax rules could help. If you pay someone to watch your child so you can work, there may be a way to cover part of that bill with money the IRS never taxes. It is called a dependent care flexible spending account, or FSA, and your employer must offer it before you can use it. You set aside a chosen amount from each paycheck before tax, then spend it on care for a child under the current figure, which the official source publishes each year or for another dependent who cannot care for themselves. The most a household can set aside in a year is the current figure, which the official source publishes each year. Sign up during open enrollment. Guess low if you are unsure, since money you do not spend can be lost.

The whole of it

What it is

I once watched a young mother at a school pickup line do sums on the back of an envelope. She was trying to learn whether the second job was worth it once the daycare bill came due. You may know that feeling. Childcare can cost as much as rent, and it comes due every month, whether the week was good or bad.

A dependent care FSA is a plan your employer sets up. It lets you move part of your pay into a special account before income tax takes its bite. Then you use that money to pay for care that lets you and your spouse go to work. Think of it as a small fence around some of your pay. Inside the fence, the tax does not reach.

If you are wondering who counts, the care has to be for a qualifying person. That means your child under the current figure, which the official source publishes each year. It can also mean a spouse or another dependent who cannot care for themselves and lives with you more than half the year. The care must let you work or look for work. If you are married, your spouse generally must be working or in school too.

Many kinds of care count. Daycare centers, after school programs, in home sitters, and summer day camps can all qualify. Overnight camps do not. Tuition for kindergarten and higher grades does not. Care by a relative can count in some cases, but not if you claim that relative as your dependent. Ask first.

How it works

You choose a yearly amount during open enrollment. Your employer splits it across your paychecks and pulls it out before income tax is figured. You also skip Social Security and Medicare tax on that money, which is a piece many people forget to count. Then you pay your care provider and send in a claim. Many plans give you a debit card or let you upload a receipt.

Here is the part that trips people up. A dependent care FSA pays you back only from what is already in the account. Say you have put in 500 dollars so far and the bill is 1,200 dollars. The plan pays out 500 for now, and the rest waits for later paychecks. A health FSA works differently, since you can spend the full year's amount early. This one does not. Patience is part of the deal.

Your choice is meant to hold for the whole plan year. You can change it only after a qualifying life event, such as a birth, a marriage, or a real change in your care costs. Ask your benefits office what counts at your company, because each plan words it a little differently.

Plans also differ on what happens to leftover money. Some follow a use it or lose it rule, with a short grace period or none at all. Your plan document tells you which one applies. Read it before you pick a number.

The numbers, and where to find yours

The yearly cap is the current figure, which the official source publishes each year per household. Married couples who file together share one cap, so you cannot each claim it. If you file as married but separate, a lower limit may apply, which is the current figure, which the official source publishes each year. The age cutoff for a child is the current figure, which the official source publishes each year. Congress sets these numbers, and they can change.

Your own numbers live in three places. Your employer's benefits guide will say whether a dependent care FSA is offered and when your plan year runs. Your pay stub will show what you already put in. And your care provider must give you a name, an address, and a tax ID number, which you will need to claim your money and to file your taxes.

The IRS explains the rules in Publication 503, called Child and Dependent Care Expenses. It also covers Form 2441, the form you file with your tax return to report this care. Read the pages for the current year, since the limits are printed there with the date.

One more thing is worth knowing. There is also a tax credit for childcare costs, called the Child and Dependent Care Credit. You cannot use the same dollars for both. Money paid through your FSA cannot also be counted for the credit. Publication 503 walks through how the two fit together.

A worked example

Let me tell you about a woman named Denise. She earns 52,000 dollars a year as a dental office manager. Her husband, Marcus, works full time as well. They have a daughter, age four, in a daycare that costs 900 dollars a month.

Denise's employer offers a dependent care FSA. She decides to set aside 5,000 dollars for the year. Her yearly daycare bill is 900 dollars times 12 months, which is 10,800 dollars. So 5,000 dollars sits well under what she will spend. It also sits at or below the household cap.

Now the tax math, using a made up income tax rate for the sake of the example. Say Denise pays 12 percent federal income tax on her last dollars of pay. Her income tax saved is 5,000 times 0.12, which is 600 dollars. She also skips Social Security and Medicare tax, which together come to 7.65 percent. That saving is 5,000 times 0.0765, which is 382.50 dollars. Add the two, and she keeps 600 plus 382.50, which is 982.50 dollars more of her own money.

Her state may treat the account differently, so this figure is only the federal piece. Her real saving depends on her own tax rate. Denise checks her most recent pay stub and last year's return to find it.

Each pay period she puts in a slice. With 26 paychecks, that is 5,000 divided by 26, or about 192.31 dollars a check. She pays the daycare, files her claim, and gets paid back as the money builds up. By year end she has spent 10,800 dollars on care. Of that, 5,000 dollars went through the account, and 5,800 dollars came from her regular pay.

Nothing was lost. That was her whole goal.

Where it goes wrong

I know a man who set aside too much and learned the lesson in December. The biggest slip is overshooting. Say you set aside 5,000 dollars and your child care ends in June, so you may not spend it all. Under a use it or lose it plan, the unused part goes back to the employer. So think about summers, school breaks, and any date your care might end.

Another slip is counting things that do not qualify. Overnight camp, private school tuition, and a babysitter for a night out are not covered. Kindergarten and up school fees do not count, though before and after school care can. If you are unsure, ask your plan administrator before you pay.

You may also forget the provider paperwork. You need the tax ID or Social Security number of whoever cares for your child, and a sitter who will not give you one can make your claim hard to file. Ask for it at the start. It is a small request.

Some people overlook the spouse rule. If one of you does not work, the account may not apply to you. There are exceptions for a spouse in school or unable to care for themselves. Check Publication 503 for your case.

Last, some folks assume the FSA always beats the tax credit. It does not. For some households the credit is worth more. Publication 503 and a tax preparer can help you compare your own numbers.

Questions to answer before you leave this page

Does my employer offer a dependent care FSA, and when does open enrollment begin? What is my plan year, and does my plan let me carry leftover money into a grace period? How much will I truly spend on care this year, counting summers and school breaks? Is my spouse working or in school, so that we both meet the rules? Do I have the tax ID of every provider I plan to pay? Have I read the Publication 503 pages for this year to see the current limit? And have I compared the FSA to the childcare credit using my own income and tax rate?