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Family finances: Opting into dependent care programs

It’s expensive to raise a child these days. In fact, according to a report from Child Care Aware, it’s more costly to pay for child care in most households than it is to pay rent.

Child in daycare

If you consider the cost of child care for two children, the cost is more expensive than paying rent in all 50 states.

With costs continuing to rise, many parents are seeking out alternative ways of paying for child care. One of the most overlooked ways to cut costs is to take advantage of a flexible spending account (FSA) offered by your employer.

How it works

I know what you’re thinking: FSA plans are only for health care expenses, right? Nope. Employers can offer tax advantageous FSAs for medical expenses, child care expenses, transit expenses — and even adoption. When it comes to child care, the FSA functions just like other FSA plans. Here’s how it works:

Step one: You contribute pre-tax dollars directly from your paycheck into a designated FSA account and use it to pay for qualified child care expenses. Your employer may also contribute funds into the plan but this is not very common for dependent care FSAs.

There is no step two. It’s that simple.

The rules

There are some rules, of course.

Working parents: You — and your spouse, if you are married — must be working or looking for work. I know it seems terribly unfair, but you may not use an FSA to pay for qualified child care expenses if you’re a stay at home parent.

Qualifying dependent: You can only use the funds to pay for the cost of qualifying child care expenses for a qualifying dependent. For purposes of the FSA, a qualifying dependent means your qualifying child under the age of 13; your spouse who is unable to care for himself or herself (and lived with you for more than half the year or another person was physically or mentally disabled and unable to care for himself or herself — some additional restrictions apply).

Legitimate provider: Your child care provider must be legitimate. You can’t pay under the table and claim the expense for purposes of an FSA: You’ll have to provide identifying information for your child care provider on your tax return. Additionally, your child care provider may not be your spouse, your dependent or your child who is under age 19.

Monetary limits: The Internal Revenue Service limits the amount you can put into a dependent care FSA. Those limits are $5,000 per year for married couples filing jointly and individual filers who are single parents or $2,500 per year for married couples filing separately. Unlike a health care FSA, you can’t take money out of a dependent care FSA in one fell swoop — it must be pro-rated throughout the year.

Plan wisely

The funds in an FSA are subject to the “use it or lose it” rule. That means that money inside of the plan must be withdrawn for qualified child care expenses — if you don’t use the funds, they are forfeited.

Keep in mind that an FSA is subject not only to the Internal Revenue Service rules but also those of your employer. If you have questions about contribution limits or other administrative details, ask your HR person.

Finally, while you can combine a dependent care FSA with the child and dependent care credit on your tax return, you may not use the same expense for both. If you plan to use both, you must subtract the amount of money reimbursed by your FSA before calculating the credit. If you have to choose between the two, run the numbers both ways and find which option is the most tax advantageous. It’s always a good idea to check with your tax professional to see what works best for you.

More about family finances

The new tax picture in 2013
Claiming dependents on your taxes
Tax consequences of gifts to kids

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