Salary Reduction Arrangements
Employers can give you tax-free dependent care assistance in a number of ways. Most often, dependent care assistance is delivered by means of a Flexible Spending Arrangement, or FSA plan. Under such plans, employees request that an annual amount of up to $2,500 be withheld in equal installments from their paychecks and set aside in a special account by the employer.
The employees benefit because the salary reductions are made before any federal income, Social Security, or Medicare taxes are paid - in effect, the employee is able to pay for child care with pretax dollars.
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Save Money
Where both spouses work for employers that provide FSAs, and one spouse has a salary that is higher than the Social Security ceiling, the other spouse should be the one to sign up for the FSA to maximize family tax savings. This is because FSA amounts are not taxed for income, Social Security, and Medicare taxes. Your "discount" for using the FSA will be greater if you would otherwise have been subject to Social Security taxes on the amount.
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During the year, each employee using an FSA submits bills for daycare, babysitting, and other qualified expenses to the plan, and is reimbursed up to the amount set aside in his or her individual account. Requests for reimbursement are monitored to make sure that the expenses are work-related, apply to a qualified individual, and meet the other requirements.
One drawback to the arrangement is that you must decide how much you want to contribute to your FSA once a year, usually in November or December for the coming year. Once requested, the amount may not be changed during the calendar year unless you experience a "major life event" such as a birth, death, marriage, or divorce.
If you don't have enough qualifying expenses during the year to use up your FSA contributions, you forfeit the remainder of your account back to your employer.
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Did You Know?
Besides being extremely painful, forfeiting any unused funds in a FSA defeats the tax benefits of deferring money into such an account. According to a May 18, 2005, IRS notice, however, employers are now permitted to modify their FSAs to extend the deadline for reimbursement of health and dependent care expenses up to 2-1/2 months after the end of the plan year. This adds true flexibility to a tax break that was "flexible" in name only.
The tax laws generally prohibit deferring compensation by means of a cafeteria plan. A plan that permits employees to carry over unused elective contributions or plan benefits from one plan year to another is a form of deferred compensation; therefore, employee plans generally require that unused contributions or benefits remaining at the end of the plan year be forfeited under a "use it or lose it" provision.
This rule is now modified to provide that a cafeteria plan document may be amended to provide for a 2-1/2 month grace period immediately following the end of a plan year. Expenses for qualified benefits incurred during this grace period may be paid or reimbursed from benefits or contributions that were unused at the end of the plan year.
Unused benefits or contributions relating to a particular qualified benefit may only be used to pay or reimburse expenses incurred with respect to that benefit; unused benefits or contributions may not be cashed out or converted to any other benefit. Any benefits remaining unused after this grace period will be forfeited under the "use it or lose it" rule as before. |
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Employees who have a FSA plan available to them must compare its benefits with the tax credit in order to see which tax break is better for them.
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