Daycare Flexible Spending Arrangements

Posted by Matt

My wife Leah and I went through our companies annual enrollment process recently and found that we had a new option to evaluate this year: the Dependent Daycare Flexible Spending Arrangement (aka Daycare FSA). If you aren't familiar with these, they are essentially an account that you automatically make pre-tax contributions to via payroll deduction and then claim reimbursements from when you incur daycare expenses.

Daycare is a significant expense, even though our son only goes three days a week and we have him in a home-based center instead of one of the larger "institutions" like KinderCare. Quick aside; the home based daycare:

• has two care providers and only about 5 or 6 kids, which is a much better ratio than we found at the larger centers
• offers three organic meals a day plus snacks
• has a crib or bed for each child in a dark bedroom away from the play area
• offers "Parent's Night Out" on some weekends, so we don't have to find a babysitter and our son can be in an environment he knows. It is fun for him, too, as the kids usually watch a movie and eat a special dinner (breakfast food, pizza, etc.)

All these great features and more mean that our daycare dollars are money well spent, but it is still a lot of money. Even at three days per week, the cost would exceed the $5000 annual maximum contribution for an FSA, and our son will probably switch to full time next year, so we'll appreciate the tax break.

There is also a federal tax credit available for dependent daycare expenses, but expenses paid via the FSA can't be claimed for a credit, so we had to go through a worksheet to figure out which was better. The one we used is proprietary to my company, but you can easily find similar worksheets online (click here). Essentially you have to calculate the tax benefit for each option and take the larger of the two. Make sure you have last year's tax forms available as the calculations require you to know things like your tax bracket and adjusted gross income. I also found a nice rule of thumb:

As a general rule, if your adjusted gross income (AGI) is more than $ 14,000, the Dependent Day Care FSA may provide greater tax savings.

We determined that the FSA was our better option and decided to set aside the full $5000. We'll probably spend more than that and I believe that we will be able to claim the tax credit for those additional expenses. I should note here that the money set aside it "use or lose" for the designated year, so be careful when determining how much to set aside. (In 2005, this was softened somewhat with the addition of a 2 1/2 month grace period to carry over unused money to the following year.)

We signed up through my employer, though the plan from my wife's employer was fairly similar. Starting in January, my take-home paycheck will be reduced in order to fund the FSA. As we make payments to the daycare, we just have to submit a claim form (with receipt) for reimbursement. The reimbursement is done via direct deposit, which is nice.

If you have children in daycare (care for senior dependents living at home is also eligible), definitely consider this option. It just takes a little effort to submit the claim forms, but the savings are definitely worth it. I did the calculations on scrap paper, so I don't have the exact number, but I think our projected savings from using just the FSA will be about $1600.