What are the pros and cons of a Dependent Care Spending Account?

Question

How will this affect how I file for taxes? I normally don't itemize. I just take the standard deduction. I heard that there are many factors involved including EIC or Child Tax Credits. I want to know what is more (typically) beneficial.

Answer 1

A Dependent Care Spending Account ("DSCA") offers two significant tax advantages. First, it allows you to pay for elegible child care expenses using before-tax dollars. Second, it reduces you adjusted gross income. Unmarried individuals may contribute up to $2500 per year, and married may jointly contribute up to $5000 per year.

The advantage of using before-tax dollars is that you don't pay tax on these earnings. For example, let's say you child care bill for next year will be exactly $5,000, and the marginal federal plus state tax rate you and your wife pay on your earnings is 40%. Without a DSCA, you would have to dedicate $8,333.33 of your income to pay that $5,000 expense. With a DSCA, the impact to your income is exactly $5,000. So you get to keep the $3,333.33 less taxes for yourself. At a 40% tax rate, that's $2,000 more in your pocket at the end of the day.

But it gets better. Many tax calculations and benefits are pegged to your adjusted gross income ("AGI"). Your marginal tax rate and the deductibility of your itemized deductions are two of the most common items affected. As your AGI increases so does your Taxable Income ("TI"). You may get bumped into a higher marginal tax rate, and nobody likes that. Also, your ability to fully deduct your itemized deductions is phased out at higher income levels. This in turn increases TI and also pushes you into a higher tax bracket.

There is one major disadvantage to a DCSA and one pitfall to watch out for. The disadvantage is that if you don't spend the money on elegible expenses in the year you make the contribution, you lose it. (Although you would still enjoy the benefit of lowering your AGI.) That's a big penalty; so you better be pretty sure you will be able to spend the money before you commit.

The pitfall is that if you hold onto your receipts until the end of the year (year 1), you could run the risk of getting reimbursed in year 2. If in year 2 you receive the maximum reimbursement from year 2 contributions, you would have been over-reimbursed ($5000 from year 2 plus $X from year 1), and any excess over $5000 in reimbursement would be taxable in year 2. So start out right be getting reimbursed right away.

Answer 2

You have recieved some good information about the tax advantages of a dependent care account. Your employer has put this plan in place and the summary plan description will tell you haw much you can put into the account pre-tax. It doesn't matter if you are single or married the maximum amount is what any employee may elect to put into the plan.
I have never in more than twenty years seen anyone lose on a dependent care account. You would simply divide the allowable amount that you can put into the account by twelve. Compare the result with what you are spending on child care monthly. You would elect to defer the lower amount so that each month you are reimbursed what was withheld from your pay check. If you lose your job the withholding stops and you would still get reiombursed for the amount you spent on child care up to that point.
I personally see it as a can't lose deal.

Answer 3

The money you put into a Dependent Care Spending Account comes out of your paycheck before taxes, so it reduces the amount of tax you pay on each paycheck. You don't claim the money as a deduction on your tax return, because you never paid the tax on that income in the first place. So you get the benefit even if you don't itemize deductions. I don't know about EIC or Child Tax Credits.

Importantly, you must use all the money in your account by year's end, or you lose it. (I think you can reclaim the money after year's end, as long as it's for expenses during the year.)

I recommend TurboTax or similar software; it handles all those things automatically after gathering the information from you.

Answer 4

Pro: tax free
Con: You must spend it all before the end of the year or you lose it.