Dear Tax Talk,
I have recently become a federal employee and have an opportunity to start a flexible spending account. We currently spend approximately $12,000 per year in child care expenses for our two children, and our flexible spending account limits each of us to $5,000 in dependent care contributions (my spouse is also a federal employee). I understand about the use-it-or-lose-it risk, but are there any other drawbacks to using this program, e.g., reductions in any other tax credits or allowable deductions? This seems to be a too-good-to-be-true offer.
For a government employee you’re awfully skeptical of its promises. A cafeteria plan, including a flexible spending account, or FSA, is a written plan that allows employees to choose between receiving cash (i.e. additional salary) or taxable benefits, instead of certain qualified benefits for which the law provides an exclusion from wages.
If an employee chooses to receive a qualified benefit under the plan, the fact that the employee could have received cash or a taxable benefit instead will not make the qualified benefit taxable. Qualified benefits include dependent care assistance.
Dependent care assistance is the amount you pay for the care of your dependents who are under age 13 (or any age if incapacitated) so that you, if unmarried, or you and your spouse, if married, can work.
Dependent care expenses are claimed on Form 2441. Under a flexible spending account, an employee can exclude up to $5,000 in wages for dependent care. The exclusion is the same for married and unmarried spouses. If both spouses exclude more than the $5,000 limit, the excess is included as wages when preparing Form 2441, Part 3.
For two children, you and your spouse can claim up to $6,000 in dependent care expenses that are eligible for the generally 20 percent credit on Form 2441. The $6,000 limit is reduced by the amount of tax-free assistance you received.
Hence, in your case, you and your wife can do the $10,000 flexible spending account, but you’ll include $5,000 in wages when preparing your Form 1040, and the most you can claim a credit for is $1,000. The deferral is advantageous, as it will probably save you tax at higher than the 20-percent rate you receive a credit for, and also saves payroll, or FICA, taxes.
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