Child Care Tax Credit vs Child Care FSA for 2021

[JamesFan]

I have 2 kids and can claim up to $16000 Child Care Tax Credit, with 50% tax return.

But I also contributed $5000 Child Care FSA. My company allows me to rollover all the $5000 to 2022.

If I reimburse $5000 of the day care fee, I would only be able to claim $11000 Child Care Tax Credit.

Question is, can I rollover the $5000 FSA and claim the full $16000 Child Care Tax Credit? Those $5000 will show up in my 2021 W2 form I believe since I see it in my 2020 W2.

Will TurboTax handle this or I have to reimburse those $5000 and then claim up to $11000 child care credit?

[BillM223]

The intention of the Dependent Care FSA is to collect tax-advantaged dollars to pay for child and dependent care.

The purpose of the change in the Taxpayer Certainty and Disaster Relief Act of 2020 was to help taxpayers who suddenly did not have access to child care because of COVID to carry over unpayable amounts in your FSA from 2020 to 2021. This was updated to also allow similar carry over from 2021 to 2022. 

It was not the purpose of the Act to allow you to move contributions around (that you have already spent) to maximize your Dependent Care Credit..

So, have you already spent the $5,000 from the FSA on dependent care in 2021? Then I think you ought to report it that way. This is what would be in your employer's FSA records and the care provider's records, right?

It's true that you report the contributions to the FSA (the amount in box 10 in the W-2) on line 12 of the 2441, and then on line 14, you subtract the amount carried over to next year back out so that you end up on lines 14-26 with all zeroes (which lets you apply all of the $16,000 to the Dependent Care Credit according to the form), but I don't know if this would survive the audit when the auditor notices that you had already spent the $5,000 on dependent care and then decided not to report it that way.

To me this is an unknown situation created by many law changes within a short timeframe, creating unforeseen situations which the IRS perhaps has not addressed. So I am not advising you to do it, but if you do, document everything and go into it with open eyes in case of an audit.

[BillM223]

I have looked at Notice 2021-15 and Notice 2021-26 which both address issues related to changes in the dependent care FSA programs (also the changes apply to health care FSAs, but this does not apply to your question).

In both notices, the consistent reference to amounts to be carried over is to "unused amounts", that is, amounts that you or your employer contributed to your dependent care FSA but which you did not spend on dependent care in 2021. 

But if I understand your situation correctly, you have already spent the $5,000 out of your FSA in 2021 on dependent care, so this amount is not an "unused amount". 

Thus, my opinion is that any amounts that you actually paid in 2021 could not be considered for carryover to 2022.

@JamesFan

[Opus 17]

If you did not request reimbursement from the FSA custodian and the full $5000 is still in your account:

If I worked through form 2441 correctly, then you can indeed leave the money to be carried over to use during the 2022 grace period, and you can apply your care costs toward the credit, up to $8000 of costs for one child and $16,000 of costs for 2 children.  However, make sure you don't also have an FSA for 2022 (because you would exceed the allowable amount) and make sure you can use up that $5000 within the grace period.

If you already requested reimbursement from your expenses:

There is no legal way to put the money back in the FSA.  If your plan allows this, they are breaking the law.  You would apply the first $5000 of costs toward the FSA, and could still claim a further $3000 (one child) or $11,000 (two or more children) toward the credit.

[JamesFan]

Actually I spent more than $16000 in daycare in 2021 but haven't requested any reimbursement of my 2021 $5000 FSA yet.

And I also pre-elected another $5000 FSA for 2022 which will roll up to $10000 FSA which I plan to use in 2022.

Are you sure I "would exceed the allowable amount" if I use all the $10000 to reimburse 2022 expense?

I talked with our HR department and the answer I got is I have $10000 to spend if I don't reimburse my 2021 expense.

[Opus 17]

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@JamesFan wrote:

Actually I spent more than $16000 in daycare in 2021 but haven't requested any reimbursement of my 2021 $5000 FSA yet.

And I also pre-elected another $5000 FSA for 2022 which will roll up to $10000 FSA which I plan to use in 2022.

Are you sure I "would exceed the allowable amount" if I use all the $10000 to reimburse 2022 expense?

I talked with our HR department and the answer I got is I have $10000 to spend if I don't reimburse my 2021 expense.

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Under current law, the maximum allowable FSA reverts to $5000 for 2022.  You would certainly have $10,000 in your account to spend.  But when you report on your 2022 tax return that you spent $5000 in current benefits and $5000 in carryover, the overall $5000 limit will be applied, and the other $5000 will be added back to your taxable income.  There is no additional penalty in this case, but you don't get a $10,000 tax break, just the $5000 allowed by law.  

I don't know what's in the long-delayed "build back better" but it might include another temporary increase of the FSA limits on the basis of the continued "emergency", in which case things might change (if it passes).  As of now, what I wrote above is what will happen under the current tax laws. 

[JamesFan]

That makes total sense to me. I have the deadline of 3/31/21 to spend the 2021 $5000 FSA, will see if any policy change before that.

It is now clear I have 2 choices:

1. Spend 2021 $5000 now and everything is clear.

2. Keep the 2021 FSA to use in 2022 and there might be quite a few uncertainties. Worst situation is put $5000 back to taxable income, but still get a bit more tax benefit since my federal+state tax rate is still less than 50%.

 Is there possibility that all the $10000 is tax free since they're allowed in my FSA? This is my first time to see Dependent Care FSA rollover. 

[Opus 17]

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@JamesFan wrote:

 Is there possibility that all the $10000 is tax free since they're allowed in my FSA? This is my first time to see Dependent Care FSA rollover. 

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Not unless Congress passes another modification.  Under the current law that applies in 2022, you get up to $5000 tax-free.  It doesn't matter if it is coming from current contributions or a carryover.  

Basically, for each year, you can choose the credit or the exclusion, but not both.  (The math on which saves more money changes when the law changes, but the basic rule is always the same.)  If you choose the credit for 2021, you can't use the carryover to take a double exclusion in 2022.

Using the full $16,000 credit and carrying the FSA funds over to next year is the best result financially under current law, as long as your AGI is less than about $165,000.   If you think you can predict what Congress will do next year, you're smarter than I am.  

[JamesFan]

@Opus 17 

Does the following mean the 2020 FSA can roll over with 2021 and reimburse up to $10500 expense?

“On March 11, 2021, The American Rescue Plan Act of 2021 (ARPA) was signed into law by President Biden. ARPA allows employers to increase the annual limit on contributions to dependent care FSAs up to $10,500 for the 2021 plan year only"

And currently the 2022 Dependent Care FSA limit remains $5000 which explains why I can't take advantage of $10000 FSA for 2022 expense?

I'll watch for any policy change before the deadline of my 2021 expense reimbursement.

And at last, if I end up with claiming $16000 child care tax credit and request all the $10000 FSA to 2022 expense, are you sure the worst situation is just pushing $5000 to taxable income, rather than losing that $5000?

Thanks for all you information.

[Opus 17 · Accepted solution]

@JamesFan 

The emergency action gave employers the option of allowing employees already enrolled in an FSA to increase their contributions to $10,500 for 2021 only.  Either your employer did not offer this option, or you did not take it when offered.  In any case, the credit is worth more for 2021 as long as your income is less than $165,000.

For 2022, the tax laws revert back to the laws that were in place for 2020, unless Congress passes a new modification.  Under the 2020/2022 rules, the maximum exclusion is $5000.   Even if you had contributed $10,500 and managed to carry it all forward, you could only exclude $5000 from your income and the other $5500 would be added back to your taxable income on your 2022 tax return.  

[JeanGeslin]

I am in a similar situation: we spent more than $16,000 in child care for our 2 children. My wife elected for a $5,000 FSA. We have already requested reimbursement for the full amount and it's reported in Box 10 of my wife's W-2.

When we filed our taxes, we realized that the dependent care credit would be more beneficial for us. So my question is can we include the $5,000 in our taxable income and claim the full dependent care credit?

I checked a few IRS publications, and it sounds that we can decide whether we want to exclude the FSA from our income. For example Publication 503 states that "If you received dependent care benefits that you exclude or deduct from your income, you must subtract that amount from the dollar limit that applies to you.".  Does that mean that we are not required to exclude them?

Thank you!

[JillS56]

No, you can not elect to include the FSA funds in your income and tax the dependent care deduction.   The purpose of the change was not for this purpose.   In order to get any child-dependent care credit, the amount of the FSA is going to first be applied to the dependent care expense.   If your dependent care exceeded the FSA then the remainder of your dependent care expense will be considered for the dependent care credit.  

The intention of the Dependent Care FSA is to collect tax-advantaged dollars to pay for child and dependent care.  The purpose of the change in the Taxpayer Certainty and Disaster Relief Act of 2020 was to help taxpayers who suddenly did not have access to child care because of COVID to carry over unpayable amounts in your FSA from 2020 to 2021.  This was updated to also allow similar carryover from 2021 to 2022.

This carryover is to help those parents who have FSA withholdings reported in Box 10 their W-2 but do not have the daycare expenses to apply the funds.   So that they do not have to report the excess of unused funds on daycare, it allows you to carry over the unused portion.  Notice 2021-15 and Notice 2021-26 both address issues related to changes in the dependent care FSA programs (also the changes apply to health care FSAs, but this does not apply to your question).

In both notices, the consistent reference to amounts to be carried over is to "unused amounts", that is, amounts that you or your employer contributed to your dependent care FSA but which you did not spend on dependent care in 2021. 

Also, there is nothing that states if you do not take the funds out of your FSA that you can carry the full amount over.   In fact, you will find that TurboTax will not allow you to carry the full amount over if you enter daycare expenses.   If you have an amount of FSA funds in Box 10 of the W-2, that amount will be taken into consideration in the calculation of the dependent care credit.  It does not ask you if you took this money out of your account.   The fact that this is not addressed leads me to believe that it does not matter whether or not you took the funds out of the account.   

The change was only to prevent taxpayers from losing their FSA funds and then having to report them as income.   

[Opus 17]

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@JeanGeslin wrote:

I am in a similar situation: we spent more than $16,000 in child care for our 2 children. My wife elected for a $5,000 FSA. We have already requested reimbursement for the full amount and it's reported in Box 10 of my wife's W-2.

When we filed our taxes, we realized that the dependent care credit would be more beneficial for us. So my question is can we include the $5,000 in our taxable income and claim the full dependent care credit?

I checked a few IRS publications, and it sounds that we can decide whether we want to exclude the FSA from our income. For example Publication 503 states that "If you received dependent care benefits that you exclude or deduct from your income, you must subtract that amount from the dollar limit that applies to you.".  Does that mean that we are not required to exclude them?

Thank you!

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Form 2441 does not give you the option.  In part 3, you must enter the amount you received as a DCB from box 10 of your W-2.  Then your child care cost is subtracted, and the remaining child care cost is eligible for the credit on the front of the page.  You received benefits that were "excluded from your income" because they are in box 10 of your W-2 instead of being included in your box 1 taxable wages.  There's no procedure to voluntarily add the DCB to your taxable Income and then use the credit.  

[JeanGeslin]

Thanks a lot for your answer. Trying just in case. On the instructions for Form 1040 - Line 1, it says:

"But the following types of income must also be included in the total on line 1: (...)

• Dependent care benefits, which should be shown in box 10 of your Form(s) W-2. But first complete Form 2441 to see if you can exclude part or all of the benefits."

Again, it seems that excluding box 10 from Line 1 is our choice, but maybe I am misinterpreting.

Thanks a lot!