It’s that time of year again, open enrollment. The time for many to choose which insurance requirements or other company benefits. This year one benefit seems especially hard to decide. What should we do for our Dependent Care FSA given Covid?
Let the Open Enrollment Choices Roll
Given I haven’t changed companies in recent years the act of open enrollment is fairly routine. Most of my decisions roll over from last year. You can see my post on open enrollment here.
What Choices to Make for Dependent Care FSA Given Covid, the Thinking Choice
But this year there is one unique aspect that is driving some consideration. What choices to make for our Dependent Care FSA given Covid? Now I’ll be the first to admit the Dependent Care FSA dollar impact is fairly small when it comes to my income. The limit is just $5k, so this is not keeping me up all night long. But still I’d like to avoid wasting $5k so the decision is important.
Under normal years I would sign up for the Dependent Care FSA. A brief refresher, essentially a dependent care FSA allows you to put aside cash at the beginning of the year to pay cash free for child care expenses. More on the Dependent Care FSA plan can be found here, but essentially you predict your expenses at the beginning of the year and then spend out of that money tax free accordingly. Anything left at the end of the year is forfeited.
Use it Or Lose It Makes the Decision for Dependent Care FSA Given Covid More Tricky
That last line is what is important here. If you don’t spend it you lose the money. So essentially before a year starts you need to predict how much you plan to spend on child care next year, up to a 5k limit.
The Other Option: Dependent Care Credit
There is also a Dependent Care Credit option available for expenses directly paid up to 6K. However that credit has significant reduction in credit amount depending on your income. The credit starts at 35% of the first 6K in dependent care expenses and decreases by 2% for each $2K in income over a limit of $15K. The minimum is 20%. So obviously if your adjusted gross income is 40K or higher your only going to receive 20% of what you spent up to $6K via the credit. Note this credit is reduced by any Dependent Care FSA contribution you make.
Example of the Interaction Between the Credit and FSA
So for example if I did an FSA of 5K and I spent 8K. Then 5K would be paid tax free by the FSA. I’d also receive a tax credit of 1K (6K dependent care limit-5k FSA) * .20 (the percentile per income level assuming you have an adjusted gross income over 40k). That tax credit would be 200 on top of the 5K deduction from the FSA.
At a Higher Income the FSA is More Valuable
So the problem is, those of us whom are higher income get more value from the FSA then the credit. Let’s assume you are in the 32% tax bracket. By using the FSA you save $1800 dollars a year in taxes if you use the Dependent Care FSA (5K*.32+1K*.2).
But if you go purely on the tax credit you only adjust off $1200 dollars (6K*.2). A $600 dollar difference is not a huge number, but it’s also not beer money. Added to that, the dependent care tax credit comes into play after adjusted gross income is calculated. The Dependent Care FSA, like a 401k, comes in before. That may be important for keeping your adjusted gross income below threshold for other parts of the tax code.
So we can establish there is some greater value to the Dependent Care FSA with the credit versus just the credit for those in higher income brackets. But is that value worth the risk of locking the funds up in a way that is use it or lose it?
Risk Mitigation and the Dependent Care FSA
Well, first we need to understand the lose it aspect. You can adjust your contributions to a Dependent Care FSA provided you have a life event. I talked a bit about one I had in this post and adjusting up or down our contribution. A life event could be one spouse no longer working (both spouses must be working to collect either the credit of FSA), losing your job, or even removing your child from day care entirely for some sort of free child care.
Special 2020 Covid FSA Provisions
Honestly in 2020 we did just that to remove ourselves from the FSA after our day care shuttered. In addition special provisions were put in place for 2020 to allow employers the option for people to change their contributions without reason. These provisions were employer adoption optional so your mileage may very. Anyway, they don’t extend to 2021 so that probably should not impact your decisions for open enrollment.
Which brings us to our situation. 2 of our kids have passed out of the age group of needing daycare during the school year. Our foster child qualifies for state provided daycare so long as she is a foster child. So we do not need child care while school remains open.
But child care doesn’t begin or end with the school year. Under the credit and FSA expenses for things like day camps count if you are using them to be able to work. We will do exactly that, sign our kids up for day camps so my wife’s business can continue while I do my W-2 job.
The Problem with the Dependent Care FSA Given Covid
The problem is, FSA contributions are monthly averaged throughout the year. So by the time of a summer day care event there would most likely be half of a year’s FSA contributions in that account. As noted you can change contribution amounts for a Dependent Care FSA mid-year given a life event, say a Day camp closing for the summer.
Covid Uncertainty and Day Camps
But what you can’t do, is get the money you’ve already put in out. You basically have to spend it. Which brings us back to Covid. I have no way to predict where Covid will be in June of 2021. None of the day camps could be open. I might not even know that until the month before they are scheduled to start. Worse still there might be nothing available for the entire summer to pickup the slack should that occur.
Which essentially means putting money in a Dependent Care FSA for next year given Covid for me is a bet that things will be clear for day care next summer. I suspect it is the same for others reading this.
Is a 5K Risk Worth a Potential Max $600 Upside?
Looking at the obvious trade offs, by using the FSA you are betting up to $5K on a potential payoff of up to $600 (assuming the FSA won’t allow you to avoid a phase out of some other tax provision). If you are wrong you could potentially lose all $5K.
I Went with the Credit
Ultimately I have decided such a bet on a Dependent Care FSA during Covid is not one I am willing to make. Sure losing $5k won’t kill us, but risking $5K for $600 does not seem so smart. We are not wishing $5K of any income limits. Instead we will use the Credit this year.
If our situation were different, for example we were still using day care during the school year, my answer would probably be different. Traditionally I’ve found the cost of daycare each month exceeds the monthly contribution. So if I had to reduce the contributions to 0, based on what was already spent there would be no lost residual.
Anyway, this may seem like an offal lot of words for $600 for those in the higher income bracket. In a way it is. But at very least I wanted to write it to get you to think about the ramifications here. $600 dollars might be a drop in the bucket, but losing $5k could constitute your yearly vacation budget. Don’t let this one go by on autopilot.
For those with younger kids, have you decided whether to continue contributing to a Dependent Care FSA given Covid?