A dependent care flexible spending account (FSA) is a benefit small business employers can provide employees. Like all benefits, it can increase your employees' loyalty to your company. But this particular benefit also helps your employees manage the expense of caring for dependents while reducing their tax liability.
According to ConnectYourCare, as of 2018, 67% of companies offer dependent care FSAs. Employers, however, are not required to offer it. The question for you, as a small business owner, is does this benefit strengthen your employee relations?
What is an FSA?
A dependent care FSA is part of a category of benefits called "flexible spending accounts" or "flexible spending arrangements." HealthCare.gov defines an FSA, in general, as "a special account you put money into that you can use to pay for out-of-pocket healthcare costs." FSAs are only available through you, the employer, and they are tax-free accounts.
FSAs can be split into two categories. A healthcare FSA (HFSA) is designed for your own medical expenses. A dependent care FSA (DCFSA) has an entirely different purpose, though it still offers tax advantages.
What is a dependent care FSA?
Most people are familiar with the healthcare FSA. Whereas an HFSA allows an individual to set aside tax-free dollars to pay for certain medical costs, a dependent care FSA is designed for members of the workforce who have the responsibility of caring for dependents.
Specifically, it can ease the financial burden of the "sandwich generation," which refers to employees responsible for both children under 18 and aging adults. The Pew Research Center indicates that 12% of parents are in that financial – and emotional – squeeze. Credit Karma notes that for one-third of households, child care costs represent 20% of their annual budget.
For employers, offering this benefit is not only considerate, but it can also prevent employee tardiness and absenteeism and boost productivity. With this employee benefit, your employees' family care issues are less likely to interfere with their ability to show up or distract them at work.
How does a dependent care FSA work?
Employees with a dependent care FSA have a percentage of their wages automatically deducted from each paycheck. They then use this money to pay for an IRS-eligible expense associated with care for children under 13, children of any age with disabilities, or a spouse with disabilities, and other types of dependents, such as aging relatives who are unable to attend to their own needs.
Contributions to a dependent care FSA are pretaxed, meaning the deductions are made from earnings before the salary is taxed.
As for how employees transact the actual payments for care services, they can pay for these services either using a debit card or out of pocket, later applying for reimbursement. The latter option involves paperwork.
Services that are eligible for reimbursement are those that make it possible for the employee to work, such as these:
- 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 by nannies
- Summer day camp
- Before- and after-school care
These are some of the services that are not eligible for reimbursement:
- Overnight recreational activities such as sleepover camps or extended field trips. That is because it is assumed employees are not at work, so they should be available for care
- Educational programs per se, including tuition for private schools
- Enrichment programs, such as ballet lessons
- Meals not directly provided by a third-party care provider. For example, a dad taking a kid out for fast food does not qualify
- 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?
The regulations on qualifying dependents are clearly defined in DCFSA regulations. To qualify, an employee's dependent has to meet these criteria:
- They must live with the employee in question for at least half of the year.
- They have to 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?
To qualify for a dependent care FSA, the employee, if married, must have a spouse who also works (or who has a disability that precludes them from working). If the employee is divorced, only the custodial parent can use the FSA. It is possible, too, for employees who have never married to use a dependent care FSA.
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 $2,750 annually. The limits are set by statute and increases related to inflation are not applicable.
Once the annual contribution is set, it is locked in long term. Only a milestone event, such as the birth of the child or divorce, permits the employee to change the contribution amount. Each year, the employee must re-enroll in the program.
One negative of FSAs is that they have a use-it-or-lose-it stipulation. That is, if an employee doesn't spend all of the money in the account during the plan year, they forfeit it. Consequently, this program is best suited for an employee with predictable care expenses.
For example, a nanny in Toledo, Ohio, charges $325 a week for 50 weeks a year. The other two weeks, the parent is on vacation and able to care for their 10-year-old child. The parent withdraws that amount from their FSA weekly until the $5,000 is spent. That removes $5,000 from taxable income.
On the other hand, another parent, whose extended family takes care of the children for free, has no regular expenses. Therefore, that employee might lose most, or all, of their FSA savings. However, there has been a tax reduction on earnings.
Employers can provide partial solutions for the use-it-or-lose-it dilemma. One is to set the program up so that up to $500 can be rolled over at the end of the calendar year and applied to the following year. Another possible solution is to provide a grace period of 2.5 months after the end of the plan year for employees to spend what is in the account. If the funds are not spent in that grace period, funds are forfeited.
Can an employee make changes to their FSA after the plan year starts?
The IRS has left this rule to the discretion of the employer. Since FSA plans are not required by law, employers have the choice in how the plans are administered.
Typically, there are limitations on what the IRS will tolerate in order for FSA programs to qualify for tax benefits. In light of the COVID-19 pandemic, the rules were softened in 2020 and remain that way today. Midyear changes are now allowed, but only if the employer agrees to administer the changes.
Employees, as far as the IRS is concerned, 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?
In many ways, a dependent care FSA and a healthcare FSA are similar. Both share the features of pretax deposits, limits on the amount of deductions from wages, use-it-or-lose-it provisions, and carryover/grace allowances.
The healthcare FSA, though, can be used to pay for many of the expenses health insurance does not, 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, if you do, you must inform employees that they have to enroll in both plans separately.
Benefit Resource Inc. reports that one-third of employees do not realize this, therefore they potentially 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 – the two types of accounts cannot be comingled. [Read related article: HSA vs. FSA: What Impact Does it Have on Employers?]
Should I offer a dependent care FSA to my employees?
As many business owners know from experience, some benefits attract certain kinds of employees and not others. For example, you might provide a superior retirement plan. But that doesn't appeal to members of Generation Z. Their financial focus is paying off student loans. (Approximately 8% of businesses offer repayment assistance with student loans as an employee benefit.) [Read related article: Should You Offer Student Loan Repayment to Employees?]
FSA vs. child care tax credit
The child care tax credit is another way to find financial advantages to pay for child care. The credit is based on the amount of money a person spends on child care. A total of $3,000 per child (for one or two children) can be claimed with this credit. Claimed expenses are deducted from taxable income.
There are trade-offs between the FSA and child care tax credit. One advantage of the tax credit is that it is simpler. A person who is already paying for child care can simply deduct the right amount from their taxes. With an FSA, the employee has to contribute money to the program first and then spend it on qualifying expenses.
The tax credit has a higher maximum deduction as well. FSAs cap at $5,000, while the child care tax credit caps at $6,000.
That said, for anyone who has an income high enough that they do not qualify for the full tax credit, the FSA may be better financially. FSA accounts are more accessible to middle- and high-income earners, while the tax credit is optimized for lower incomes.
Offering a dependent care FSA may not be worth it unless it appeals to the types of workers you need. An ideal candidate for a dependent care FSA would belong to the sandwich generation and be in a high tax bracket. The maximum would not cover most of their dependent care expenses, though it would help. Also, there is the tax advantage.
On the other hand, your workforce might consist of those who have a support system of family members or others who provide care free of charge. Those employees may not be in a financial position to redirect funds from their paychecks to dependent care – and no, they don't need a tax break. For them, the better deal might be the child tax credit. Yes, they are eligible for both a dependent care FSA and the tax credit, but they might not welcome the possibility of depositing funds to an FSA and losing them.
Offering broad benefits like a dependent care FSA can give your company an edge. Since the 1942 Stabilization Act, when employers began providing benefits instead of raising salaries, a worker's choice to join and stay with a company frequently involved the allure of benefits such as health insurance. That is more applicable today when, despite stagnant wages, costs continue to increase.
Workers who get help from their employers with that sustained inflation, from child care to healthcare, are likely to 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.