Dependent care FSAs are a benefit many employees find appealing, and it could help your company attract top candidates.
A dependent care flexible spending account (FSA) is a benefit small business employers can provide employees. Like all benefits, it can increase your employees' loyalty to your company. But this particular benefit also helps your employees manage the expense of caring for dependents while reducing their tax liability.
According to ConnectYourCare, as of 2018, 67% of companies offer dependent care FSAs. Employers, however, are not required to offer it. The question for you, as a small business owner, is does this benefit strengthen your employee relations?
What is a dependent care FSA?
A dependent care FSA is part of a category of benefits called "flexible spending accounts" or "flexible spending arrangements." Investopedia defines an FSA, in general, as "a type of savings account that provides the account holder [employee] with specific tax advantages." FSAs are only available through you, the employer.
Most people are familiar with a healthcare FSA. However whereas a healthcare FSA allows an individual to set aside tax-free dollars to pay for certain medical costs, a dependent FSA is designed for members of the workforce with dependent-care responsibilities.
Specifically, it can ease the financial burden of the "sandwich generation," which is, employees responsible for both children under 18 and aging adults. The Pew Research Center indicates 12% of parents are in that financial – and emotional – squeeze. Credit Karma notes that for one-third of households, child-care costs represent 20% of their annual budget.
For employers, offering this benefit is not only considerate, but it can also prevent employee tardiness and absenteeism, as well as boost productivity, because your employees' child-care and aging parent issues are not interfering with employees' ability to show up for work nor are they lacking focus at work because they are distracted by what is going on with their loved ones.
How a dependent care FSA works
Employees with a dependent care FSA have a percentage of their wages automatically deducted from each paycheck. They then use this money to pay for an IRS-eligible expense associated with care for children under 13, children of any age with disabilities, or a spouse with disabilities, and other types of dependents, such as aging relatives who are unable to attend to their own needs.
Contributions to a dependent care FSA are pretaxed, meaning the deductions are made from earnings before the salary is taxed.
As for how employees transact the actual payments for care services, they can pay for these services either using a debit card or out of pocket, later applying for reimbursement. The latter option involves paperwork.
Services that are eligible for reimbursement are those that make it possible for the employee to work. They include:
- Application fees and deposits for care services. (Care must be furnished; otherwise, there is no reimbursement.)
- Day care for children or adults
- Physical care, such as by nannies
- Summer day camp
- Before- and after-school care
Services that are not eligible for reimbursement include:
- Overnight recreational activities such as sleepover camps or extended field trips. That is because it is assumed employees are not at work, so they should be available for care
- Educational programs per se, including tuition for private schools
- Enrichment programs, such as ballet lessons
- Meals not directly provided by a third-party care provider. For example, a dad taking a kid out for fast food does not qualify
- Housecleaning, if it's not connected to services rendered to care for children or those with disabilities
- Child support payments
What are the terms and conditions of employee contributions?
To qualify for a dependent care FSA, the employee, if married, must have a spouse who also works (or who has a disability that precludes them from working). If the employee is divorced, only the custodial parent can use the FSA. It is possible, too, for employees who have never married to use a dependent care FSA.
A single person or married couple filing taxes jointly can contribute up to $5,000 annually to a dependent care FSA. A married couple filing separately can contribute $2,750 annually. The limits are set by statute and increases related to inflation are not applicable.
Once the annual contribution is set, it is locked in long term. Only a milestone event, such as the birth of the child or divorce, permits the employee to change the contribution amount. Each year, the employee must re-enroll in the program.
One negative of FSAs is that they have a use-it-or-lose-it stipulation. That is, if an employee doesn't spend all of the money in the account during the plan year, they forfeit it. Consequently, this program is best suited for an employee with predictable care expenses.
For example, a nanny in Toledo, Ohio, charges $325 a week for 50 weeks a year. The other two weeks, the parent is on vacation and able to care for their 10-year-old child. The parent withdraws that amount from their FSA weekly until the $5,000 is spent. That removes $5,000 from taxable income.
On the other hand, another parent, whose extended family takes care of the children for free, has no regular expenses. Therefore, that employee might lose most, or all, of their FSA savings. However, there has been a tax reduction on earnings.
Employers can provide partial solutions for the use-it-or-lose-it dilemma. One is to set the program up so that up to $500 can be rolled over at the end of the calendar year and applied to the following year. Another possible solution is to provide a grace period of 2.5 months after the end of the plan year for employees to spend what is in the account. If the funds are not spent in that grace period, funds are forfeited.
How a dependent care FSA comapares to a healthcare FSA
In many ways, a dependent care FSA and a healthcare FSA are similar. Both share the features of pretax deposits, limits on the amount of deductions from wages, use-it-or-lose-it provisions, and carryover/grace allowances.
The healthcare FSA, though, can be used to pay for many of the expenses health insurance does not, including deductibles for health insurance and co-payments for medical treatments.
Employers can set up both dependent care and healthcare FSA benefits for employees. However, if you do, you must inform employees that they have to enroll in both plans separately.
Benefit Resource Inc. reports that one-third of employees do not realize this, therefore they potentially miss out on the benefits. Also, many people mistakenly assume that a dependent care FSA can help pay for dependents' medical expenses. However, that is not the case – the two types of accounts cannot be comingled. [Read related article: HSA vs. FSA: What Impact Does it Have on Employers]
Should I offer a dependent care FSA to my employees?
As many business owners know from experience, some benefits attract certain kinds of employees and not others. For example, you might provide a superior retirement plan. But that doesn't appeal to members of Generation Z. Their financial focus is paying off student loans. (Approximately 8% of businesses currently offer as a benefit repayment assistance with student loans.) Read related article: Should You Offer Student Loan Repayment to Employees?]
Offering a dependent care FSA may not be worth it unless it appeals to the types of workers you need.
A suitable candidate for a dependent care FSA would belong to the sandwich generation and be in a high tax bracket. The maximum would not cover most of their dependent care expenses, though it would help. Also, there is the tax advantage.
On the other hand, your workforce might comprise those who have a support system of family members or others who provide care free of charge. Those employees may not be in a financial position to redirect funds from their paycheck to dependent care. And, no, they do not need a tax break. For them, the better deal might be through the Child Tax Credit. Yes, they are eligible for both a dependent care FSA and the Child Tax Credit, but they might not welcome the possibility of depositing funds to an FSA and lose them.
Offering broad-based benefits like a dependent care FSA can give your company an edge
Since the 1942 Stabilization Act, when employers began providing benefits instead of raising salaries, choosing and staying with a company frequently involved the allure of benefits such as health insurance. That is more applicable today when, despite stagnant wages, costs continue to increase.
Workers who get help from their employers with that sustained inflation, from childcare to healthcare, are likely to 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.