Lecture 32 Dependent Care Taxation Dependent Care as an Employee Benefit Flexible Spending Accounts Use of Tax Credit Dilemma in Choosing FSA or Tax Credit Examples

Taxation Benefits are deductible for the employer and tax free to the employee Limits –$5000 for single parents and married filing jointly –$2500 for married filing separately Restricted to care for child under 13, or someone mentally or physically unable to care for themselves Nondiscrimination rules –If not met, benefits are taxable income to HCEs

Dependent Care as an Employee Benefit On-site day care centers Arrangements with local day-care centers Reimbursements to employees Information and referral services

Flexible Spending Accounts Employee selects the amount to be withheld from salary prior to the beginning of the year Taxable income is reduced –State –Federal –Social Security for employer and employee When expenses are incurred, employee files for reimbursement Major problem - Forfeiture –Any amounts not used to cover allowable expenses during year are forfeited to the employer –Amounts forfeited can be used by employer for any purpose except returning to affected employees

Use of Tax Credit Child and Dependent Care Expenses - Form 2441 Credit runs from 30% (for AGI $28,000) Credit is applicable % times the lowest of: –$2400 for one child or $4800 for two or more children –Actual expenses –Earned income of lower paid parent

Dilemma in Choosing FSA or Tax Credit Lowest paid employees with more than one eligible child are generally better off using the tax credit If your tax rate (Federal + State + Social Security) exceeds your tax credit percentage, you may be better off using FSA If you use the FSA, it reduces the dollar for dollar the maximum limit you are entitled to under the tax credit

Example 1 Married couple filing jointly with 4 year old twins will spend $9,000 in day care expenses Eligible for 20% tax credit Tax rates –Federal 28% –State 3% –Social Security 7.65% If they use the tax credit, it is worth $960 (20% of $4800) If they put $5000 in an FSA, it saves them $ (38.65% of $5000) Choice - FSA for $5000

Example 2 Single parent with 8 and 10 year old children spends $2000 per year in after school care Eligible for 30% tax credit Tax rates –Federal 15% –State 3% –Social Security 7.65% If parent uses tax credit, it is worth $600 If parent puts $2000 in an FSA, it saves $513 Choice - Tax credit

Dilemma Single parent with 2 children, 2 and 14. Child care expenses for 2 year old will be either $2500 (if 14 year old can care for 2 year old during the summer) or $5000. Eligible for the tax credit at the 27% level Tax rates –Federal 15% –State 3% –Social Security 7.65% What should this parent do?

Dilemma - (cont.) Tax credit –If expenses are $2500 or $5000 Tax credit = $648 (27% of $2400) FSA of $2500 –If expenses are $2500 or $5000 Tax savings of $ (25.65% of $2500) FSA of $5000 –If expenses are $2500 Tax savings of $ (25.65% of $2500) Forfeiture of $2500 Total effect - loss of $ ($ $641.25) –If expenses are $5000 Tax savings of $ (25.65% of $5000)