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Is American Rescue Plan Act of 2021 making Dependent Care FSAs a bad deal for most taxpayers?

Forum|Forum|5 years ago
March 9, 2021
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I read today in the text of the next Covid relief bill that Congress is set to make massive changes to the Child and Dependent Care Tax Credit for 2021. Namely, for a large range of income levels, the credit is changing from 20% of up to $3000 of expenses per child to 50% of up to $8000 per child. This creates an interesting (and potentially frustrating) change because now the tax credit is worth more than the deduction you'd receive from a dependent care FSA for all but the highest earners.

My understanding is that contributions to the dependent care FSA reduce the amount of expenses eligible for the tax credit, so does that mean that those of us who use the FSA are now increasing our tax bill from signing up for the FSA rather than reducing it? Should most people with dependent care FSAs immediately stop contributing to them for the rest of 2021 (since that option was added in the last Covid relief bill) in order to minimize their tax liability for the year?

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Best answer by Opus 17

I have not read the news reports or the text of the proposed law, but if it is as you say, then the credit becomes better than an FSA.

Prior to the 2018 tax reform law, the FSA was a better option at incomes above about $22,000, because the benefit of the FSA increased as your marginal tax rate increased while the credit went down as your income went up. Because the tax reform law reduced the marginal tax rates, the FSA and the credit came out almost exactly equal at an income range as high as $70,000 or $80,000, if I remember correctly. (I spent part of an afternoon comparing different scenarios and trying to understand the impact of the law on the dependent care FSA, although I did not save my calculations. The impact of state income taxes was impossible to calculate because reducing your income reduces your state tax, but some states also had a dependent care credit that would’ve applied at the FSA was not used.)

If your report of the proposed change is accurate, then the Democratic Congress has picked a clear winner, and making people with employer provided FSA clear losers. It remains to be seen whether the IRS would offer a administrative provision similar to last year in which they would allow people to cancel their FSAs early or offer some other kind of relief. You will just have to pay attention as the year goes on.

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gloriah5200

Regarding the American Rescue Plan Act-

“This has not yet become law.”

https://blog.turbotax.intuit.com/tax-news/american-rescue-plan-what-does-it-mean-for-you-and-a-third-stimulus-check-49041/

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Opus 17Answer

Employee

I have not read the news reports or the text of the proposed law, but if it is as you say, then the credit becomes better than an FSA.

Prior to the 2018 tax reform law, the FSA was a better option at incomes above about $22,000, because the benefit of the FSA increased as your marginal tax rate increased while the credit went down as your income went up. Because the tax reform law reduced the marginal tax rates, the FSA and the credit came out almost exactly equal at an income range as high as $70,000 or $80,000, if I remember correctly. (I spent part of an afternoon comparing different scenarios and trying to understand the impact of the law on the dependent care FSA, although I did not save my calculations. The impact of state income taxes was impossible to calculate because reducing your income reduces your state tax, but some states also had a dependent care credit that would’ve applied at the FSA was not used.)

If your report of the proposed change is accurate, then the Democratic Congress has picked a clear winner, and making people with employer provided FSA clear losers. It remains to be seen whether the IRS would offer a administrative provision similar to last year in which they would allow people to cancel their FSAs early or offer some other kind of relief. You will just have to pay attention as the year goes on.

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Michael129

Whether you contribute to the FSA is not the determinitive question. You can still deduct those dependent care expenses for which you have not been reimbursed from your FSA (or paid out of directly). In other words, this is a matter of careful accounting. If you want to take full advantage of the increased tax credit, make sure you spend only after-tax dollars on the first $8000 of dependent care expenses. Any dependent care expenses in excess of $8000 can be spent from your FSA again.

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Opus 17

Employee

@Michael129 wrote:

Whether you contribute to the FSA is not the determinitive question. You can still deduct those dependent care expenses for which you have not been reimbursed from your FSA (or paid out of directly). In other words, this is a matter of careful accounting. If you want to take full advantage of the increased tax credit, make sure you spend only after-tax dollars on the first $8000 of dependent care expenses. Any dependent care expenses in excess of $8000 can be spent from your FSA again.

No. Under current regulations, the maximum FSA is $5000 and the maximum child care credit is $6000, but the $5000 FSA exclusion counts against the $6000 limit. In other words, if you have a $5000 FSA and provide care for two or more children, and spend $5000 from the FSA and $5000 out of pocket, your maximum eligible expense for the credit is $1000. The FSA is always accounted for first.

The American Rescue Plan Act has 2 relevant provisions.

§9631 increases the eligible expense limit for the dependent care credit from $3000 for one child and $6000 for two children, to $8000 for one child and $16,000 for two or more children. The maximum credit is raised from 35% to 50%, and the phaseout begins at $125,000, not $15,000. There is a second phaseout beginning at incomes over $400,000, so that very high income taxpayers will eventually become ineligible, whereas under pre-2021 law, the bottom percentage remained at 20% for everyone.

§9632 increases the amount of income that can be excluded from income tax using an FSA from $5000 to $10,500. This change is retroactive to FSA plans that start their plan year after Dec 31, 2020, and employers can allow employees who have plans in place to modify the amount they want to contribute. If you have a plan that starts in mid-year, you can't change your current plan but the new limit will apply when your plan re-starts in mid-year.

The sections that coordinate the FSA benefit and the child care credit are not changed, so whatever you spend on childcare, the FSA money comes first, and anything you pay out of pocket after the FSA is used up, your child care credit limit is reduced by the FSA amount.

All these changes are for 2021 only and revert back to the old rules on January 1, 2022.

Now, for some unofficial tax advice.

Since the child and dependent care credit has been increased to a maximum of 50% of eligible expenses, and the income phaseout does not start until you get to an AGI of $125,000, the credit is unarguably a better deal for 2021. If you are already enrolled in an FSA (maximum $5000 under the old rules), I don't see anything in the law that will allow you to back out of it. However, if your expenses are more than $5000, you will have up to $3000 additional eligibility if you pay for care for one qualifying persona and $11,000 of additional eligibility if you pay for care for two qualifying persons, and those amounts would be credited at 50%, as long as your income is less than $125,000.

If you did not enroll in an FSA yet because your plan starts mid-year, you probably will be better off skipping it this year and using the tax credit only.

If your plan allows you to change your FSA contributions, you should take the opportunity to stop your FSA contributions and rely on the credit instead, unless your income is more than $125,000. (I don't think this will be allowed, but I am not a lawyer, and there might be something in the law I have misunderstood. You will have to wait and see what your employer says.)

If your income is more than $125,000, there will be a break point somewhere, where the FSA becomes better than the credit, but I am not going to try and calculate it now.

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schuess10

How does the phaseout over 125k work? We have AGI of about 165k, 2 kids in daycare so expenses are well over the 16k. Currently doing FSA for 5k that just carried over from last year. Should we try to cancel for the year if we have the option?

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Opus 17

Employee

@ajohannigman wrote:

My understanding is that contributions to the dependent care FSA reduce the amount of expenses eligible for the tax credit, so does that mean that those of us who use the FSA are now increasing our tax bill from signing up for the FSA rather than reducing it? Should most people with dependent care FSAs immediately stop contributing to them for the rest of 2021 (since that option was added in the last Covid relief bill) in order to minimize their tax liability for the year?

Specific answers to your questions.

The ability to modify or stop your contributions extends to plan years ending in 2021 (such as a calendar year plan from January 1-December 31). Although I'm not sure if that is in the law or is an administrative relief, it is covered in IRS notice 2021-15.

https://www.irs.gov/pub/irs-drop/n-21-15.pdf

The employer is not required to permit changes, but "may permit eligible employees" to make certain changes.

I believe that for taxpayers with incomes under about $177,000, the revised child care credit is a better tax savings than an FSA. You likely can't retrieve money already contributed, but if your employer permits you to stop your contributions, that is probably the way to go. Be aware, however, I am not an accountant, and the IRS has not released any regulations yet on this. The text of the law seems to take this position.

Then, you would claim the credit on your tax return for any amount not covered by the FSA, up to the new limits of $8000 for one qualifying child and $16,000 for two or more qualifying children receiving day care. If you provide care for 1 child and already had $1500 taken out as FSA contributions and your employer allows you to stop them, you could apply up to $6500 of additional expenses toward the new credit.

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ajohannigmanAuthor

Thanks for your very detailed replies. Fortunately my employer is allowing mid-year changes due to the second covid bill so I've been able to stop contributions for now.

I calculated the break-even point for my situation as ~$147k household income (seems like the FSA limit has also increased to $10,500 which changes the math a bit) which we will not hit this year pending some unexpected windfall from an unknown source, so as a parent of 1 child it's looking like the best I can do now is ~$1k FSA contribution (already taken out) and a credit of 50% of $7k expenses for the rest of the credit limit for my 2021 taxes. That leaves me paying about $200 more than the ideal, but I can't complain too much since, assuming nothing else changes in this chaotic year, I'm still going to be owing several thousand dollars less this year than I thought I would a couple months ago.

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Opus 17

Employee

@ajohannigman wrote:

Thanks for your very detailed replies. Fortunately my employer is allowing mid-year changes due to the second covid bill so I've been able to stop contributions for now.

I calculated the break-even point for my situation as ~$147k household income (seems like the FSA limit has also increased to $10,500 which changes the math a bit) which we will not hit this year pending some unexpected windfall from an unknown source, so as a parent of 1 child it's looking like the best I can do now is ~$1k FSA contribution (already taken out) and a credit of 50% of $7k expenses for the rest of the credit limit for my 2021 taxes. That leaves me paying about $200 more than the ideal, but I can't complain too much since, assuming nothing else changes in this chaotic year, I'm still going to be owing several thousand dollars less this year than I thought I would a couple months ago.

My very rough guess that the break point would be around $177,000 didn't take state taxes into account. You may be closer to the target.

Best of luck.