Author Topic: Weird 2018 Tax Sweet (Sour?) Spot: Dependent Care FSA not a good deal?!  (Read 857 times)

KnitsWithFIRE

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Last year it (barely) made sense for us to set aside the full $5k for dependent care in my work FSA, and we did it again this year -- but after using the newly released IRS witholding calculator for 2018, it looks like our tax bill will be $500 HIGHER for having used the FSA!  What the . . . ?!  With all the paperwork involved, and the fact that our daycare expenses are nearly 5 times that and the FSA is a drop in the bucket, this is SO frustrating!  Is anyone else in the same boat?  PLEASE tell me I'm entering something incorrectly!

Filing Status: MFJ
Number of Jobs: 2
2 Dependents (ages 1 and 4)
No other credits
Total salary: 110,761
Dependent care expenses: 23,500 (My understanding is I can only claim 6,000 if not using FSA, OR 1,000 if putting full 5,000 in FSA)
Total plans and cafeteria, not including FSA: $14,597 (::facepunches::, we're working on cutting spending and upping our retirement but holy cow daycare $$$)

My results:
NO FSA at all: $3080 in taxes
Full $5k to FSA, claim the remaining 1,000 as expenses: $3564 in taxes
Just the freebie $600 from my employer, claim the remaining 5,400 as expenses: $3200 in taxes

Any tax aficionados out there care to weigh in? Many thanks in advance!!!

terran

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Note that I don't have kids, so before this question I knew very little about the dependent care credit or dependent care FSA, so take this with whatever grain of salt that merits.

I just took a look at Form 2241 - Child and Dependent Care Expenses and I think I figured out what's going on. The dependent care credit is calculated based on the your actual dependent care expenses or $3000/dependent up to 2 dependents ($6000 max), whichever is less. If you receive dependent care benefits from you employer (box 10 form W2), which I think is your FSA then, as you pointed out, the amount of expenses eligible for the credit is reduced by your dependent care benefits. So if you contribute the full $5000, then the the expenses the credit can be based on is at most $6000 - $5000 = $1000. So basically you can get a deduction for at most $6000, and that's split between the FSA and the dependent care credit.

The dependent care credit is based on AGI (line 38, form 1040) with different amounts of the deduction ($1000 or $6000) being multiplied by between 20% (any AGI over $43k) to 35% (AGI under $15k). You should be over $43k AGI, so your credit will either be $1000 x 20% = $200, or $6000 x 20% = $1200, so a $1000 advantage to not using an FSA in terms of the credit.

If you use an FSA you shouldn't pay FICA on the contribution (check with your employer, but usually these are run through a section 125 "cafeteria" plan that avoids FICA), so that's $5000 x 7.65% = $382.50 savings, meaning the advantage of not using the FSA drops to $1000 - $382.50 = $617.50. Since you'll also get a federal and maybe state tax deduction on the FSA contribution, that means if your marginal federal (and maybe state) tax bracket is anything more than $617.50 / $5000= 12.35%, then the FSA is better, and if it's less then skipping the FSA is better.

I just realized I took a kind of backwards approach to that, but I'll leave it since it might help depending on how you think. Another way to think about the marginal rate breakeven point is the 20% from the form 2241 table minus 7.65% FICA, which is also 12.35%.

So really this comes down to state taxes, because I think you should be in the 12% bracket, so as long as the dependent care FSA is deducted from your state taxable income and your marginal state bracket is more than 0.35%, then you should come out ahead overall with the FSA.

It looks like you're saying you also get $600 in the FSA from your employer if you contribute? That changes the math (in your favor) since it gives you less space to contribute, but also free money! So then, the FSA advantage becomes $4400 x 7.65% = $336.60 FICA savings plus the $600 free money advantage is $936.60. Compared to the $1000 No FSA advantage, that's a $63.40 net No FSA advantage. So as long as your marginal Federal and maybe state tax bracket is more than $63.40 / $4400 = 1.44% (which it definitely is), then the FSA is better.

Of course, the flip side is that by reducing FICA you're reducing your eventual social security benefit, so there's that to be considered too.

KnitsWithFIRE

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ONE MILLION THANKS!  I completely forgot the FICA advantage; I was so shocked by the results of the witholding calculator that my brain stopped there.  I truly appreciate your time and fresh eyes! I feel much better! 

Yes, I get $600 free from my employer if I sign up; I have the option to do JUST the $600 which was making my head spin with possibilities.

This thank you feels woefully short in comparison to your thoughtful reply -- THANK YOU AGAIN!!!

terran

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Since you get the $600 whether or not you contribute you're back to the 12.35% advantage for no FSA before the FSA tax deduction is accounted for. You definitely want to take the $600 because $600 (from your employer) is better than 20% of $600 (from tax savings from the larger dependent care credit).

So altogether, I would say if your state does NOT allow an FSA deduction (or you live in a no income tax state) then you don't want to contribute to the FSA as you federal marginal rate is likely 12%.

If your state does allow an FSA deduction then it's a bit of a grey area as you'll save your state marginal rate less 0.35%, but you'll also reduce your eventual social security benefit (which has a greater effect for early retirees who often have less than 35 years of earnings) and also has a greater effect for lower income people (those under the ~$127k cap, and especially those under the 1st or 2nd bend point). Or maybe social security will go away or be calculated differently in the future, so maybe it's better to take the tax break now, who knows?
« Last Edit: March 01, 2018, 11:34:45 AM by terran »

KnitsWithFIRE

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Who knows, indeed :)  This is exhausting!  We're in NY.