How Dependent Care FSAs Can Reduce Your Taxes and Ease Student Loan Stress

Paying for dependent care expenses, like childcare, can strain your budget. A dependent care flexible spending account (DCFSA) might help you plan for childcare costs, as long as it's used for eligible expenses.

Here’s what to know about a dependent care FSA, how it affects your taxes and can potentially ease student loan-related financial pressures.

What is a dependent care FSA?

Like other flexible spending accounts (FSAs), a dependent care FSA lets you set aside pre-tax dollars from your paycheck. Later, when you need reimbursement for qualified expenses, you can use the money in the account to cover the costs.

You’ll often find FSAs through your employer. If it offers a program, you can contribute to a dependent care FSA after enrollment. Your contributions reduce your taxable income, and this money can cover some of your childcare costs while you work.

For tax year 2023, you can contribute up to $5,000 in a DCFSA. As with other savings accounts, spending accounts and tax benefits, the IRS adjusts the annual contribution limit based on various factors. Review your benefits during open enrollment to determine what works best for you.

Eligibility criteria for participating

To enroll, you need to meet some criteria:

• Dependent. An eligible dependent is a child, under the age of 13, who lives with you at least half the year, or a minor or adult (spouse or close relative) who lives in your home and is incapable of caring for themself.
• Income. You must have earned income and receive access to a DCFSA benefit through your employer.
• Expenses. You incur childcare costs, such as after-school programs or adult day care, while at work.
• Care providers. A care provider usually must provide a taxpayer identification number (TIN) or Social Security number (SSN), but you might be able to use DCFSA money for care services, even without that information.

The dependent care FSA helps you set aside money for care costs so you can better budget for them — while giving you a tax break.

How FSAs work

The first step in leveraging a DCFSA is enrolling through your employer. You’ll need to decide how much you’ll need to save toward dependent care expenses, up to the annual contribution limit. The amount you define is deducted from your paycheck throughout the year. The money is then put into a separate account through direct deposit, and you can draw on it to cover qualified expenses.

The tax benefit comes because you have the money taken from your paycheck before deducting federal and state tax amounts. As a result, FSAs reduce your taxable income and, in some cases, might even bring your taxable income to a lower tax bracket.

Pros and cons of using an FSA for daycare expenses

When considering a DCFSA, weighing the benefits and drawbacks is important. Here's a look at the pros and cons of using an FSA for daycare costs to help you make an informed decision.

How to use an FSA to lower your AGI

When calculating your federal income tax at the end of the year, you don’t pay taxes on your total gross income. Instead, your income is adjusted with deductions, like contributions to an FSA. For most taxpayers, this adjusted gross income (AGI) forms the basis for your tax bill going forward.

Because your AGI on your federal tax return is less than the total amount you earned, you’ll likely have a lower tax bill. This adjustment puts your financial health in a better position overall.

For example, without the DCFSA, an annual taxable income of $45,000 puts you in the 22% tax bracket. Now, let’s say you enrolled in your employer’s DCFSA plan, and contributed the maximum $5,000 for the year. 

This drops your taxable income to $40,000, bringing you to a lower 12% tax bracket. According to the calculator provided by FSA Feds, your estimated tax savings is $600 in that tax bracket.

How a spouse and your tax filing status impacts your FSA

Although both parents might have a dependent care FSA, the total contributions for a couple who’s married, filing jointly, is $5,000 in 2023. You can’t combine both accounts for a $10,000 contribution.

Additionally, your filing status matters when contributing to the DCFSA. If you’re filing your taxes as single, or married filing jointly, you can contribute up to $5,000. If you’re married, but filing separately, your contribution limit is $2,500.

If you’re divorced, you’ll need to pay attention to custody rules, too. You must be the custodial parent, even if the child is one of your tax dependents. A tax professional can help you determine how to fill out your IRS form and what you’re eligible for.

Reducing student loan payments through FSA contributions

Making FSA contributions to a DCFSA can reduce your AGI and affect your monthly student loan payments. A lower AGI means a lower monthly payment on an  income-driven repayment (IDR) plan.

You can use our Income-Based Repayment calculator to compare different plans based on your AGI.

Let’s say you don’t contribute to a DCFSA, and have the following scenario:

• Married filing jointly, with a household of three people.
• Your current AGI is $65,000.
• You have $50,000 in total student debt, with 40% of that from graduate loans, with an average interest rate of 6%.
• Your spouse doesn’t have student loan debt.

Under the old REPAYE plan, you’d pay $231 per month. But with the new SAVE plan, your monthly payment is $53. 

If you max out your DCFSA contributions, thereby reducing your AGI to $60,000, your payment is even lower at $24 per month. Just by contributing to your dependent care FSA, you’ve cut your monthly payment by more than half.

Each year, moving forward, you’ll save $348 on federal student loan payments. Over 10 years, you’re looking at more than $3,000 saved on student loan payments just from this decision. After 25 years, that’s $8,700 in monthly payment savings.

Realize, though, that there are different scenarios for using your AGI to reduce your student loan payments. Run the numbers to see whether married filing separately leads to better results than being able to put more into a DCFSA. Your filing status also affects the repayment plan you qualify for.

Maximizing dependent care FSA contributions

Maximizing your contributions can make sense as you attempt to manage your budget.

• Determine how much you generally spend in qualified expenses, such as daycare, summer day camp (not sleepaway camp), after-school care and other programs.
• During annual benefits enrollment, decide how much of each paycheck you’d like deducted to hit your savings goal. If you get 26 paychecks a year, and you can max out your $5,000 contribution, that’s $192.30 per paycheck.
• If your expenses are more than $5,000 a year, consider whether you qualify for the child and dependent care credit. You can’t claim the same expenses for both, but it’s possible to divide your expenses and use some to justify the DCFSA contributions and other expenses for the dependent care tax credit.

Carefully consider how to plan and estimate your costs beforehand, including how you can use tools like the DCFSA to help you save up for these costs and lower your tax bill.

We at SLP Wealth can walk you through these considerations and build a plan moving forward. Contact us today.