More Tax Savings with DCFSA or the Child and Dependent Care Tax Credit?

Which Results in More Tax Savings: Dependent Care Flexible Spending Account (DCFSA) or the Child and Dependent Care Tax Credit?

Edward A. Zurndorfer

Many federal employees have young children and/or dependent adults for whom an employee must pay child and dependent care expenses in order to allow the employee and their spouse to work. Child and adult care costs can be expensive. There are two tax preferential ways to pay for child and adult care expenses that will reduce the overall cost due to the tax savings. The first method is a dependent care flexible spending account. The other method is the child and dependent care tax credit. Both the DCFSA and the child and the dependent care tax credit are discussed, explained and compared in this column.

Dependent Care Flexible Spending Account (DCFSA)

A DCFSA allows a federal employee to be reimbursed for out-of-pocket dependent care expenses. Employees who work for an Executive Branch agency or an agency that has adopted the Federal Flexible Benefits Plan (“FedFlex”) can elect to participate in the federal flexible spending account program FSAFEDS by going to www.fsafeds.com. Two types of flexible spending accounts are offered in FSAFEDS. One is a health care flexible spending account (HCFSA or LEXHCFSA) and the other is a dependent care flexible spending account or DCFSA.

Employees who elect to participate in a DCFSA during 2022 can set aside a maximum $5,000. The funds set aside to the DCFSA are deducted from an employee’s gross salary. Employees must elect to contribute to a DCFSA for 2022 during the current “open season” which concludes at 11:59 pm, Dec. 13, 2021.

The funds contributed to DCFSA via payroll deduction are set aside before federal and state income taxes, Social Security (FICA) and Medicare Part A (hospital insurance) payroll taxes. The average tax savings for an employee earning $100,000 who contributes $5,000 to the DCFSA is $500. That means that the employee gets $5,000 worth of dependent care purchasing power plus saving about $500 in overall taxes.

To contribute to and to use the DCFSA, the employee (and the employee’s spouse, if married) must have earned income. Under Internal Revenue Code (IRC) Section 129, the maximum that can be deducted from an employee’s gross salary and contributed to DCFSA is:

• $5,000 for single individuals or a married individual filing jointly with a spouse; or
• $2,500 for a married individual filing separately with a spouse.

Qualifying Persons for DCFSA Withdrawals

Withdrawals from a DCFSA may be made to pay for qualifying dependent care expenses for the following individuals:

• Any child under age 13 who may be claimed as a dependent. If the child turned age 13 during the year, the child is a qualifying person for the part of the year he or she was under age 13.
• A disabled spouse (mentally or physically) who is unable to care for themselves, who lives with the individual more than one-half of the year.
• Any disabled person not able to care for himself or herself for whom the individual can claim as a dependent or could claim as a dependent except that the disabled person had gross income during the year of $4,300 or more.

Qualifying Expenses for the DCFSA Withdrawals

Qualifying expenses for DCFSA withdrawals include amounts paid for household services and care of the qualifying person while the individual works or looks for work. Household services are ordinary and usual services done in and around one’s home that are necessary to run one’s household. Those services include the services of a housekeeper, maid or cook.

Note that child support payments are not qualified expenses.

The cost of care provided outside the home for any dependent under age 13 or any other qualifying person who regularly spends at least 8 hours a day in the home.

Care provided at dependent care centers, assuming the center meets all applicable state and local regulations, nursery school and similar pre-schools that qualify as day care. Kindergarten does not since it is considered primarily for education rather than employment related.

Specialty day camps including basketball and soccer camps, drama camps, computers camps, etc., are qualified expenses unless it is an overnight camp. Tuitions paid for any type of overnight camp are not qualifying expenses for DCFSA withdrawals.

Any tuition-related costs to schooling for a child in the first grade or above are not qualified expenses. However, the cost of any before- or after-school care is considered qualified expenses, assuming that care is needed in order for the parents to work.

How Does the FSAFEDS DCFSA Work?

          Federal employees who enroll in the DCFSA can set aside as much as $5,000 from their gross salary during 2022. Whatever the amount the employee elects to set aside, the amounts are set aside in equal allotments spread over 26 pay periods. The following example illustrates:

Example 1. Howard elects to set aside $5,000 to his DCFSA for 2022. Starting with his first pay date in January 2022, and continuing throughout 2022, $5,000/26 or $192.37 will be deducted from Howard’s salary (before-taxed) and contributed to his DCFSA. Whenever Howard incurs a qualifying expense, he will pay it and then apply to FSAFEDS to be reimbursed from his DCFSA.

Note that Howard has to use up the $5,000 set aside to his DCFSA no later than Dec. 31, 2022.

Dependent Care Tax Credit Overview

Instead of using a DCFSA to pay for qualifying child and dependent care expenses, federal employees can benefit from a tax credit as a result of the employees paying qualifying dependent care expenses. The difference in individual tax relief between the DCFSA and the child and dependent care tax credit is that with the DCFSA, the employee uses before-taxed salary – federal and state income taxes, Social Security (FICA) and Medicare Part A (hospital insurance) payroll taxes – to contribute to the DCFSA. During the plan year, the employee pays for qualifying dependent care expenses with after-taxed dollars, and then gets reimbursed from his or her DCFSA (with before-taxed dollars) for these paid dependent care expenses.

With the child and dependent care tax credit, the employees pay the qualifying child and dependent care expenses with after-taxed dollars. When the employee files his or her federal income tax return, the employee uses the qualifying child and dependent care expenses as a basis to compute a tax credit. A tax credit reduces the employee’s federal tax liability “dollar-for-dollar.”

For 2022, the child and dependent care tax credit returns to what it was during 2020, namely: a nonrefundable tax credit of up to $1,050 for one dependent or up to $2,100 for more than one dependent. The maximum amount of qualified care expenses that may be used to calculate the tax credit are $3,000 for one dependent and $6,000 for more than one dependent. The dollar limit for more than one dependent does not need to be divided equally among the dependents as the total dollar amount.

The 2022 tax credit percentage (of qualifying dependent care expenses) reduces from 35 percent to 20 percent as adjusted gross income (AGI) increases with the phaseout beginning at AGI of $15,000 as the following table illustrates:

2022 Child and Dependent Care Tax Credit AGI Phaseout

The tax credit is computed based on qualifying expenses that (1) Enable the individual and/or spouse to work; or (2) enable the individual and/or spouse to look for work. Earned income (salary/wages) is required in order to take the tax credit.

The following example illustrates:

Example 2. Michael and Melinda are married, and each earned in their respective jobs $70,000 for a total of $140,000. They have a two-year old and a four-year old for whom they pay $6,000 in day care expenses. Their child and dependent care tax credit for 2022 is equal to 20 percent of $6,000, or $1,200.

Which Results in More Tax Savings: DCFSA or Child and Dependent Care Tax Credit?

Assumptions:

• Annual income $140,000
• Married filing jointly
• 2 children
• Cost of childcare: $6,000

The difference will depend on a number of variables including filing status, income levels, dependent care expense amount, etc. As a general rule of thumb, for individuals in a 22 percent or higher federal marginal tax bracket and on a five percent or higher state marginal tax bracket, the DCFSA is better, resulting in more net cash.

It needs to be emphasized that an employee cannot contribute the $5,000 maximum to a DCFSA and also use the $5,000 as a basis for computing the child and dependent care tax credit in the same tax year. However, because the maximum amount of qualifying child and dependent care expenses that can be used as a basis for computing the child and dependent care tax credit is $6,000, an employee who contributes to a DCFSA the maximum $5,000 to the DCFSA but occurs more than $5,000 in qualifying expenses (for more than one qualifying dependent) can use the excess expenses above $5,000 (and up to $6,000) as a basis for computing the tax credit in the same year.   

 tax savings DCFSA