Support Employees’ Child Care Needs With a Dependent Care Flexible Spending Account

What is an FSA?

A dependent care FSA is part of a broader benefits category known as flexible spending accounts. FSAs are considered a health and wellness benefit and are part of an overall employee compensation package. They let employees set aside money on a pre-tax basis to help pay for out-of-pocket healthcare expenses. They are only available through employers.

There are two primary FSA categories: 

• Healthcare FSAs. A healthcare FSA (HFSA) is designed to help with personal medical expenses. An HFSA allows an individual to set aside tax-free dollars to pay for specific medical costs. 
• Dependent care FSAs. A dependent care FSA (DCFSA) helps with dependent care expenses. 

What is a dependent care FSA?

A dependent care FSA is designed for workforce members responsible for dependent care. Specifically, DCFSAs can help ease the financial burden of the “sandwich generation” — employees responsible for children under 18 and aging adults. According to the Pew Research Center, more than half of U.S. adults in their 40s are in this demographic. And according to LendingTree research, American adults spend up to 29 percent of their income on child care.

A DCFSA is a job perk that can improve morale. It can also help prevent employee tardiness and workplace absenteeism, which in turn can increase productivity. With this benefit, your employees’ family care issues are less likely to interfere with their ability to show up on time or distract them at work.

How does a dependent care FSA work?

Employees with a dependent care FSA have a pre-tax percentage of their wages automatically deducted from each paycheck. The DCSFA annual maximum contribution limits are $5,000 per household, or $2,500 if married filing separately.

Employees can use money in their DCFSA to pay for IRS-eligible expenses associated with care for dependents in the following categories: 

• Children under 13
• Children of any age with disabilities 
• A spouse with disabilities
• Other dependents, like aging relatives who are unable to attend to their own needs

Employees can either pay for these services using a debit card or pay out of pocket and apply for reimbursement, which involves paperwork.

Reimbursement-eligible services make it possible for the employee to work and pay for dependent care. Here are some examples of reimbursement-eligible services:

• Application fees and deposits for care services (care must be furnished; otherwise, there is no reimbursement)
• Day care for children or adults
• Transportation
• Physical care, such as nannies
• Summer day camp
• Before- and after-school care

But not everything is eligible for reimbursement. Ineligible services include the following: 

• Overnight recreational activities like sleepover camps or extended field trips
• Educational programs, including tuition for private schools
• Enrichment programs, such as ballet lessons
• Meals not directly provided by a third-party care provider (for example, a parent taking a child out for fast food)
• Housecleaning, if it’s not connected to services rendered to care for children or those with disabilities
• Child support payments

Who qualifies as a dependent under a DCFSA?

Qualifying dependents are clearly defined in DCFSA regulations. To qualify, an employee’s dependent must meet the following criteria:

• They must live with the employee in question for at least half the year.
• They must spend at least eight hours a day in the employee’s residence while they live with the employee.
• They cannot file a joint tax return with their spouse unless the employee is their spouse and otherwise qualifies.

What are the terms and conditions of employee contributions?

Employee contributions to DCFSAs have specific regulations. Keep the following in mind if you’re considering implementing or using a DCFSA: 

• Employee marital status. To qualify for a dependent care FSA, a married employee must have a spouse who works or has a disability that precludes them from working. If the employee is divorced, only the custodial parent can use the FSA. It is possible for employees who have never married to use a dependent care FSA.
• Contribution limits. A single person or married couple filing taxes jointly can contribute up to $5,000 annually to a dependent care FSA. A married couple filing separately can contribute $2,500 annually. The limits are set by statute, and inflation-related increases are not applicable.
• Contributions are locked in. Once the annual contribution is set, it is locked in long-term. Only a milestone event, such as the birth of a child or divorce, permits the employee to change the contribution amount. The employee must re-enroll in the program each year.

The FSA use-it-or-lose-it dilemma

One downside to FSAs is that they have a use-it-or-lose-it stipulation. So if an employee doesn’t spend all of the money in the account during the plan year, they forfeit the remainder. Consequently, this program is best suited for employees with predictable care expenses.

Here are two examples to illustrate this point: 

• Predictable care expenses. Let’s say a nanny in Toledo, Ohio, charges $325 weekly for 50 weeks a year. For the other two weeks, the parent is off work and can care for their 10-year-old child. The parent withdraws the nanny’s payments from their FSA weekly until the $5,000 is spent. That removes $5,000 from their taxable income.
• Unpredictable care expenses. Another parent doesn’t have regular child care expenses. They have extended family who can care for their child for free. This employee might lose most or all of their FSA savings. However, there has been a tax reduction on earnings.

Employers can provide a partial solution for the use-it-or-lose-it dilemma by allowing employees a grace period of 2.5 months after the plan year’s end for spending what’s in the account. The funds are forfeited if they are not spent in that grace period.

Can an employee make changes to their FSA after the plan year starts?

Typically, there are limitations on what the IRS will tolerate for FSA programs to qualify for tax benefits. Rules were softened in 2020 because of the pandemic, and some less stringent rules remain today. For example, midyear changes are now allowed, but only if the employer agrees to administer the changes.

As far as the IRS is concerned, employees can drop or switch plans at any time of the year. The number of times your employees can do this is entirely up to you as the employer.

How does a dependent care FSA compare to a healthcare FSA?

DCFSAs and healthcare FSAs (HFSAs) are similar. Both share the features of pre-tax deposits, limits on contribution amounts, use-it-or-lose-it provisions, and grace period allowances.

However, employees can use a healthcare FSA to pay expenses that health insurance does not cover, including deductibles for health insurance and co-payments for medical treatments.

Employers can set up both dependent care and healthcare FSA benefits for employees. However, you must inform employees that they must enroll in both plans separately. Many employees don’t realize this, so they could miss out on the benefits. 

Also, many people mistakenly assume that a dependent care FSA can help pay for dependents’ medical expenses. However, that is not the case, since the two types of accounts cannot be commingled.

Should I offer a dependent care FSA to my employees?

That depends on whether your employees will take advantage of this benefit. If your employees want a dependent care FSA, there are many benefits to providing it, including the following:

• Tax savings. A dependent care FSA can help an employer save on taxes. A DCFSA reduces an employee’s taxable salary, which means you’ll pay less in payroll taxes, FICA taxes, unemployment insurance, and workers’ compensation. The FICA tax savings should offset at least part of the cost of administering this plan. 
• Happier employees. Offering a DCFSA can increase employee engagement and reduce turnover. FSAs are a great way for employees to get a tax break on medical expenses. 

FSA vs. child care tax credit

The child care tax credit is another way to help with child care expenses. The credit is based on how much money someone spends on child care. With this credit, you can claim a total of $3,000 per child (for one or two children), and claimed expenses are deducted from taxable income.

The child care tax credit offers the following benefits: 

• The child care tax credit is simpler than an FSA. The child care tax credit is simpler; someone already paying for child care can deduct the correct amount from their taxes. With an FSA, the employee must contribute money to the program first and then spend it on qualifying expenses.
• The child care tax credit has a higher deduction. The tax credit also has a higher maximum deduction. FSAs cap at $5,000, while the child care tax credit caps at $6,000.

When deciding whether to offer a DCFSA, consider the following questions: 

• Do your employees qualify for the full child care tax credit? A DCFSA may be better financially for employees whose income is too high to qualify for the full tax credit. FSA accounts are more accessible to middle- and high-income earners, while the tax credit is optimized for lower incomes.
• Are your employees part of the sandwich generation? Offering a dependent care FSA may not be worth it unless it appeals to your employees. An ideal candidate for a dependent care FSA would belong to the sandwich generation and be in a high tax bracket. 
• Do your employees have free child care? Your workforce might consist of individuals with a support system of family members or others who provide care free of charge. They may not be financially able to redirect funds from their paychecks to dependent care. For them, the child tax credit may be the better deal. While they may be eligible for both, they might not welcome the possibility of depositing funds to an FSA and losing them.

A DCFSA can foster a loyal workforce

Offering comprehensive benefits like a dependent care FSA can give your company an edge in the hiring process. Bright, talented employees want workplaces with excellent benefits and a company culture that prioritizes a positive work-life balance.

Workers who receive assistance with child care and healthcare costs will likely be grateful and loyal to your company. Offering benefits that meet the needs of most of your employees can be a smart strategy for your small business. The return on investment could be significant.

Jamie Johnson contributed to this article.