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I have a two week old newborn. In reviewing my employer's benefits within the 30 day life event window, I have noticed we have a Dependent Care FSA, which seems an exciting benefit that I was not planning on. Since we won't start daycare until about October, it's now a question for me to decide whether to start this FSA; and if so for how much, the maximum $5000 or a lesser amount. (I have a separate question to my HR department whether there is a grace period for spending at the end of the plan year. This question is about the IRS rules between the FSA and the childcare tax credit.)

This is a related question but doesn't have my details.

Check my assumptions:

After reading IRS Publication 503 am I correct that because:

  • My spouse and I each work full time

  • My spouse and I file married file jointly

we can ask the benefit administrator to deduct $5000 per year into the FSA, including with a midyear start; but because

  • We have 1 child

We are eligible for $3000 annual childcare tax credit?

Question:

Does FSA deduction greater than the child care credit cause the deducted amount to feed back into earned income (or in other words, should I not bother to take the FSA deduction for more than $3000)?

I did not find my scenario the IRS publication 503 examples (example 2 on page 12 is closest, but involves 2 children). Reading the worksheet on page 14, it appears that I would have $3000 on line 4; $5000 on line 5 and a calculated negative 2000 on line 6; this would flow to line 9, and negative values become 0 in line 10, suggesting I could take the full $5000 FSA pretax deduction. Is there another form where this would come back and bite me?

  • There's a huge difference between a deduction and a tax credit. $3000 tax credit is far bigger in just about any situation than a $5000 deduction. – xyious Jun 18 '18 at 21:31
  • @xyious so the Dependent Care FSA is categorically a bad choice? – user662852 Jun 18 '18 at 23:19
  • I'm not a tax expert so I don't know the specifics about either. But the way you describe it yes. A deduction essentially reduces your taxable income (You make 50,000 you only pay tax on 45,000). A tax credit is free money (you make 50,000, you pay 10,000 in taxes, the tax credit reduces that to 7,000, which means that you get a $3000 refund if you paid exactly as much in taxes as you were supposed to). – xyious Jun 19 '18 at 15:35
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    Check out the income reductions. As an example, if the family income is over $43k, you can only deduct 20%. That may make the FSA more meaningful. – mkennedy Jun 19 '18 at 17:29
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First determine what, if any, tax credit you would actually be eligible for based on your income or expected income. It's my understanding that for tax-year 2018, the income phase-out threshold for the child tax-credit was bumped from $75,000 to $200,000 ($400,000 for married filing jointly, with complete phase-out at $440,000). But now some of the family tax credits have been combined and I think the maximum child tax credit is $2,000. If you qualify for the full tax-credit, that's probably your optimum choice.

A tax credit is a credit against your actual tax liability. A tax deduction is adjusts your taxable income which will impact your tax liability; a $5,000 deduction might actually reduce your tax liability by $2,000. When you're dealing with deductions, not credits, payroll deductions are usually the preferred route because they're generally taken from your gross income before any tax is assessed, including Social Security and Medicare and sometimes state income taxes.

Next, if you do want to go the FSA route it's important to understand that Healthcare FSA and other types of FSA (Dependent Care, Parking, and Transit) are very different in functionality and administration. There are other questions and answers that outline healthcare FSAs very well; but a lot of that does not apply to DCFSAs. The bits that are relevant to you are:

  • you can only spend from your dependent care FSA funds already available in the FSA (the amount you have actually contributed to-date); and
  • you can adjust this election on an as needed basis
    • this will vary by employer in administration and availability but if your child is beginning daycare the rules allow your employer to allow you to enroll at that time.
    • Healthcare FSA rules require a qualified event to make a mid year election change; many employers impose this requirement on all FSAs to ease administration, but some do allow the mid-year 'as-needed' changes to other FSAs.
  • You can lose your contributed dollars if you do not submit claims appropriately under the plan guidelines.

Most of all, make sure that any information you read about the child tax credit is within the scope of the Tax Cuts and Jobs Act (Trump tax-cuts). A LOT of things changed from 2017 to 2018...

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Should I not bother to take the FSA deduction for more than $3000

FSA follows the use-it-or-lose-it model, so it only makes sense to take what you need. For example:

While you cannot receive both tax benefits for the same expenses, you may be able to claim both tax benefits if your expenses exceed $5,000. If you have two or more children, you could set aside the first $5,000 pre-tax into an FSA and claim up to $1,000 of remaining expenses for the dependent child-care credit. This means you could potentially collect the higher tax savings allotted through an FSA but not be limited to the FSA's maximum of $5,000.

References

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