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 may request that an annual amount be withheld in
equal installments from their paychecks and set aside in a special
account by the employer. Taxpayers that are single or married filing
jointly may set aside $5,000 annually. However, the annual maximum
dollar amount for married taxpayers is limited to the amount of the
spouse with the lowest earnings. Taxpayers that are married filing
separately are limited to $2,500 annually.
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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