Many employers that sponsor cafeteria plans offer flexible spending accounts. These flexible spending accounts are generally for reimbursement of eligible health care or dependent care expenses. For a general overview of flexible spending accounts, see our blog post from September 2022. Focusing on dependent care flexible spending accounts (DCFSAs), we will look at the upside and the downside of this type of benefit. This discussion is generally based on a typical participant, but keep in mind these arrangements can get complicated in individual situations.
The Upside
The most obvious upside of participating in a DCFSA is that the participant pays less in income taxes because their salary is reduced by the amount elected by the participant. If you have to pay for dependent care, you might as well pay for it on a pre-tax basis, am I right? And if the employer makes contributions towards the reimbursement of those expenses, even better. Keep in mind that participating in a DCFSA would be in lieu of taking the Dependent Care Tax Credit. While the benefits under a DCFSA are usually the best option, each individual’s income situation is different, so they would need to determine which option is the best for their circumstances.
The Downside
While we say this section will discuss the downside of DCFSAs, the following are really just limitations. That means if the participant is aware of them and plans for them, then they don’t become negatives. The basic limitations under a DCFSA that need to be kept in mind are:
- Expenses must be employment-related. The expenses must arise due to care needs for the employee or his spouse to work or look for work. This means if the spouse is a stay-at-home partner who does not work outside the home, is not looking for a job, or not a full-time student, then those expenses would not be qualified. While having a fun night out with your spouse may be important due to a lot of hard work at your job, babysitting expenses for that reason are not employment-related and therefore not be qualified.
- The “qualifying dependent” must be young or incapacitated. The dependent for whom care is being paid must generally live in the same home as the participant and be a child under age 13 or a spouse or qualifying relative unable to care for themselves. For example, Molly is in a after school care program so her parents can work. Molly turns 13 on October 15, 2023. Her after school care program costs incurred through October 14, 2023 may be reimbursed through her mother’s DCFSA, but expenses incurred for care on or after October 15, 2023 will not be eligible for reimbursement.
- Substantiation. As noted in an earlier post, the IRS has clearly stated that every expense that is reimbursed under a flexible benefits plan must be substantiated. This means that invoices, receipts, or other records documenting the dependent care expense must be provided to the administrator.
- The expense must be incurred before reimbursement. A dependent care expense must be incurred, that is, the care must be provided, before it can be reimbursed. Many dependent care providers require pre-payment of dependent care services, so this can be a problematic issue for the participant. For example, Eric pays his daughter’s babysitter at the end of March for April child care. He will not be able to be reimbursed for that expense until May, when the child care services in April have been provided. Similarly, the dependent care services must be incurred during the period of coverage, which means if Dahlia enrolls in the DCFSA effective in August, her son’s child care expenses incurred in July would not be eligible for reimbursement.
- You only get out what you have put in. Unlike a health care flexible spending account, a DCFSA can only reimburse an eligible expense up to the amount that has been contributed and not used in the account. Let’s imagine Daniel elects a salary reduction of $200 per month ($100 per bi-weekly paycheck) to be contributed to his DCFSA, and in mid-February (at which point he has contributed $300) he requests reimbursement for $500 in child care expenses that were incurred in January. He would be able to get an immediate reimbursement of the $300 he has already contributed, but would have to wait to get the additional $200 reimbursed after the next two paychecks.
- There is a limit on benefits. For each taxable year, the maximum dollar amount that can be contributed to a DCFSA is generally $5,000. This breaks down to an average monthly maximum of $417. Dependent care can easily exceed this amount, so the participant may not be able to get this tax-favored treatment on all of their dependent care expenses.
- If you don’t use it, you lose it. A notorious down-side of participating in a flexible spending account is that if you don’t use up contributions made during the plan year (subject to certain grace periods and carry-overs that may apply) then that unused amount is forfeited. This means it is very important to accurately calculate dependent care expenses for the coming plan year before making an election.
Conclusion
If you were to make a “pros and cons” list of the factors discussed above, you might see that numerically, there are more cons that pros. But that would be misleading and the quality of the overall benefit should be evaluated. Overall, when a participant is aware of the requirements and limitations, evaluates their individual situation, and carefully plans for the use of the DCFSA, the tax savings on a necessary expense makes it all worthwhile.