Dependent Care FSA while MFS

[DZ2121]

My wife and I file as “married but separately” due to my student loans. In the past, we’ve each elected the max of $2500 for the Dependent Care FSA. For 2022, however, we thought it would be easier if I elected $5000 and she elected $0 for the Dependent Care FSA. I’m now wondering if that’s prohibited and I should take action now for exceeding the $2500 limit as MSFer. Thanks.

[Opus 17 · Accepted solution]

When MFS, you can't use the dependent care credit at all, and the maximum allowed DCFSA deferral is $2500.  Additionally, only the spouse who claims a child can use the account at all.

If you only have one child, you should request full reimbursement, and you need to claim that child as a dependent.  The excess reimbursement will be added back to your taxable income but there is no additional penalty.  If you don't claim the child as a dependent, the entire $5000 reimbursement will be added back to your taxable income.

If you pay for care for 2 or more children, you lost the tax advantage of your spouse's FSA.  You could have claimed child A and up to $2500 of tax-free DCFSA, and your spouse could have claimed child B and claimed up to $2500 of tax-free DCFSA.   At this point, you and your spouse can only use the $2500 exclusion that you are allowed.

There is no action to take.  You can't modify your FSA after your open enrollment period unless you have a qualifying life event (marriage, divorce, death in the family, birth of a new child). 

I have previously discussed the pitfalls of filing MFS to get lower loan payments.  Briefly,

• many tax deductions and credits are disallowed
• you potentially lose thousands of dollars a year on your taxes, which offsets the loan payment savings
• this tax loss lasts as long as you file separately for IBR, up to 25 years
• even if you qualify for PSLF, it takes 10 years or longer, and the student loan bureaucracy is very stingy about actually approving PSLF applications
• to qualify for PSLF, you may be locked into a job or career you don't like
• if your loan is forgiven, the remaining balance becomes taxable income at that time, and the tax on the loan balance, plus all the extra taxes over the previous 10 years, may offset the loan payment savings.

Basically, filing MFS to get IBR is a risky bet at best.  You will pay a lot more in taxes now and later than you may realize.

Unless the Democrats muster enough political willpower to forgive your loans (making all the plumbers and carpenters who never went to college pay your debts), filing MFS to get IBR is probably a lot worse in the long term than you think.

Good luck.

[NCperson]

@Opus 17 while I embrace your comments on filing MFS and its pitfalls, can you please comment on this bullet again? 

• if your loan is forgiven, the remaining balance becomes taxable income at that time, and the tax on the loan balance, plus all the extra taxes over the previous 10 years, may offset the loan payment savings.

it's my understanding that federal loan foregiveness is tax free through 2025 and loan foregiveness under the PSLF program is  tax free as well (regardless of the year of foregiveness) 

[Opus 17]

@NCperson 

I wasn’t up-to-date on the provision of the rescue plan that makes a student loan forgiveness tax free up till 2025, so that would have to be figured into any calculation by married spouses. If they aren’t within the window to make it by that date, they are still looking at abandoning many years of tax benefits of filing jointly for an uncertain prospect of loan forgiveness. 

I’m not convinced about the tax free status of all PSLF.  There is a provision that student loan forgiveness is tax free for certain programs that encourage public service in underserved areas, such as graduating from medical school and opening a practice in a poor and minority rural area.  But PSLF is available to nearly anyone who works for a nonprofit, and I’m not sure (without doing a lot more research) that somebody working for a celebrity nonprofit in Hollywood (for example) would qualify for the same tax-free treatment as somebody working in rural Mississippi.  They might qualify for loan forgiveness but not the tax free part, I don’t know about that and I would have to do more research.

Even assuming all loans forgiven under PSLF are tax-free, the last reported success rate for PSLF applications was 1.34%; a million people have applied and 11,000 were awarded.  The paperwork and documentation requirements are so burdensome that 98% of applications have been rejected so far. President Biden did issue an executive order to loosen up the requirements and allow people who have been denied to cure their applications and reapply, but it is too early to know how much positive effect that will have.  And of course, PSLF only applies to government loans, not privately held student loans.

My purpose in raising these issues is to inform taxpayers that filing separately to qualify for income based reduction of payments is a mixed bag at best. The taxpayers may abandon 10 or 20 or 25 years worth of tax benefits of filing jointly, while the debt continues to increase when the low payments aren’t sufficient to pay down the principal balance.  Loan forgiveness is uncertain and may be taxable, and may depend on the winds of political fortune.  

[NCperson]

I still agree that filing MSF is a 'mixed bag'

https://studentaid.gov/help-center/answers/article/loan-amounts-forgiven-under-pslf-taxable