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

What is an FSA?

An FSA (flexible spending account) is a benefit that supports health and wellness as part of an overall employee compensation package. It lets employees set aside money on a pretax basis to help pay for out-of-pocket healthcare expenses. FSAs 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 eligible dependent care expenses. 

What is a dependent care FSA?

A dependent care FSA (DCFSA) is a tax-advantaged account designed to help employees responsible for dependent care. “A DCFSA allows employees to pay for care for their dependents with pretax dollars,” explained Gary Massey, managing director at Massey and Company CPA. “This includes expenses for preschool, summer day camp, before school and after school programs and daycare.”

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 Care.com, on average, U.S. parents spend at least $9,600 on child care costs annually — approximately 22 percent of their household income. Some even spend up to 29 percent of their income on child care alone.

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, 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 pretax percentage of their wages automatically deducted from each paycheck. The DCFSA annual maximum contribution limits are $5,000 per household or $2,500 if married and 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 age 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 while covering dependent care expenses. Here are some examples of reimbursement-eligible services:

• Application fees and deposits for care services (care must be provided; otherwise, there is no reimbursement)
• Day care for children or adults
• Transportation related to dependent care
• 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, unless directly tied to dependent care services
• 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 for more than half of the year.
• They must require care for at least eight hours a day while residing with the employee.
• They cannot file a joint tax return with a spouse unless the dependent is the employee’s spouse and otherwise qualifies.

How do employers benefit from a dependent care FSA?

If you offer a dependent care FSA, your business can enjoy the following benefits:

• 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. A DCFSA allows employees to save on taxes for qualified dependent care expenses, reducing their overall financial burden.

Should I offer a dependent care FSA to my employees?

Amy Spurling, founder and CEO of Compt, emphasized that employers must weigh the pros and cons of offering a DCFSA. “While dependent care FSAs offer important tax advantages, companies should consider whether they’re actually meeting employees’ full caregiving needs,” Spurling noted.

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 more financially beneficial for employees whose income is too high to qualify for the full tax credit. The child care tax credit provides a direct reduction in taxes owed, which may be a better option for some employees (more on this below).
• 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 is typically part of the sandwich generation and 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. If they are not financially able to redirect funds from their paychecks to dependent care, the child tax credit may be the better option (more on this below). While they may be eligible for both, they might not want to contribute to an FSA and risk losing unspent funds.
• What are the costs involved? Massey advised employers to consider the administrative costs of maintaining a DCFSA. “This will include processing and paying claims for reimbursement and ensuring that only qualifying expenses are reimbursed,” Massey explained.

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. Unmarried employees can also use a dependent care FSA if they meet the eligibility criteria.
• Contribution limits: A single person or married couple filing jointly can contribute up to $5,000 annually to a dependent care FSA, and a married couple filing separately can contribute up to $2,500 annually. The limits are set by statute, and inflation-related increases do not apply.
• Contributions are locked in: Once the annual contribution is set, it cannot be changed unless a qualifying life event occurs, such as the birth of a child or a divorce. Employees must reenroll in the program each year.

What is the FSA use-it-or-lose-it dilemma?

One downside to FSAs is that they have a use-it-or-lose-it stipulation. If an employee doesn’t spend all the money in the account during the plan year, they forfeit the remaining balance. 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 under-13-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 2 1/2-month grace period after the plan year ends to spend the remaining funds. If the funds are not used within that grace period, they are forfeited.

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

Typically, the IRS imposes strict rules on FSA programs to qualify them for tax benefits. While rules were temporarily loosened in 2020 due to the pandemic, some flexibility remains today. For example, midyear changes are now allowed, but only if the employer agrees to administer them.

The IRS permits employees to drop or switch plans during the year, but the employer determines the frequency of changes.

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

DCFSAs and healthcare FSAs (HFSAs) are similar. Both share the features of pretax deposits, limits on contribution amounts, use-it-or-lose-it provisions, and grace period allowances. However, employees can use a healthcare FSA to pay for out-of-pocket medical expenses that health insurance does not cover, including deductibles and co-payments for medical treatments.

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

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 combined.

What is the difference between a dependent FSA and the child care tax credit?

The child and dependent 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. Unlike an FSA, this credit provides a direct reduction in taxes owed rather than reducing taxable income.

With this credit, taxpayers can claim up to $3,000 for one child and up to $6,000 for two or more children. The credit applies to a percentage of qualifying child care expenses, which varies based on income.

The child care tax credit offers the following benefits:

• The child care tax credit is simpler than an FSA. With the child care tax credit, someone already paying for child care can deduct the correct amount from their taxes. With an FSA, the employee must first contribute money to the program and then spend it on qualifying expenses.
• The child care tax credit may provide a higher benefit than an FSA. The tax credit allows families to claim a percentage of qualifying expenses up to $6,000 for two or more children, while DCFSAs cap at $5,000. However, the actual tax benefit depends on income level, as the credit percentage decreases for higher earners.

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 dependent care 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.