For high-income earners, balancing a demanding career with the rising costs of childcare can quickly become a financial juggling act. Even families earning six figures can find that daycare, nannies or after-school programs absorb a surprising portion of their budget. That’s where a Dependent Care Flexible Spending Account (FSA) comes in. As a tax-advantaged tool, this account is designed to ease the financial load of dependent care. However, while this benefit is available to most employees, its value and limitations can look very different for top earners.
A financial advisor can help you determine whether a dependent care FSA is right for your financial situation and future outlook.
How a Dependent Care FSA Works
A Dependent Care Flexible Spending Account (FSA) allows you to set aside pre-tax dollars to pay for your dependent’s qualifying care expenses.
These accounts are typically available through an employer benefits package. This allows you to allocate up to $7,500 per year per household, or $3,750 if married and filing separately. The funds can cover a wide range of care-related costs, such as daycare, preschool, after-school programs and even summer day camps. By providing this care, parents are better enabled to work or look for work.
The key advantage of a Dependent Care FSA lies in its tax treatment. Contributions reduce your taxable income, which can lead to significant savings at higher tax brackets.
For example, someone earning $200,000 annually could save over $2,000 in federal income and payroll taxes with the maximum benefit. The higher your income, and therefore your marginal tax rate, the more valuable these pre-tax savings can become.
To qualify, expenses must be for the care of children under 13. It also covers adult dependents who are physically or mentally incapable of self-care.
Payments made to babysitters, licensed childcare providers or in-home caregivers generally qualify. However, payments for schooling beyond kindergarten and overnight camps are not included.
You must provide specific documentation, such as provider tax identification numbers, when submitting claims for reimbursement.
Limitations for High-Income Earners
While a Dependent Care FSA can be a useful tax savings tool, it offers limited advantages for high-income households. For many affluent families, eligible care expenses far exceed this cap. It results in a relatively modest overall tax benefit compared to overall childcare expenses.
Another key limitation is how the Dependent Care FSA interacts with the Child and Dependent Care Tax Credit. Once adjusted gross income (AGI) exceeds $43,000, the child tax credit drops to the minimum 20% rate. That means high earners already face diminishing returns on this tax credit. And, because FSA contributions can’t overlap with credit-eligible expenses, the potential combined benefit is even narrower.
High-income individuals also need to be aware of nondiscrimination testing. Employers must conduct this testing annually to ensure FSAs don’t disproportionately favor higher-paid employees. If the plan fails these tests, the employer may have to reduce or even eliminate contributions for top earners. This can unexpectedly limit or disqualify participation for executives or those in the top compensation brackets.
For wealthy families, the Dependent Care FSA’s strict reimbursement structure can also feel restrictive. Because funds are reimbursed only after care expenses are incurred and documented, participants must front the full cost of care and then wait for reimbursement.
This administrative process, combined with the relatively small tax savings, may make the FSA less impactful for those with significant disposable income.
Can High-Income Earners Benefit From a Dependent Care FSA?
Even with its limitations, a Dependent Care FSA can still offer meaningful value for high-income earners. The ability to set aside up to $7,500 in pre-tax dollars effectively shelters that amount from federal, state and payroll taxes. For someone in a 35% combined marginal tax bracket, this translates to $2,625 in potential annual savings, offering a simple, guaranteed return on expenses most families already incur.
Even for those with higher incomes, minimizing taxable income remains a crucial aspect of smart financial planning. Since FSA contributions are made before taxes, they help reduce your overall adjusted gross income (AGI). This can have secondary benefits, including reduced exposure to certain income-based phaseouts.
It can also maintain your eligibility for other tax deductions. While $7,500 may seem minor relative to total earnings, it still contributes to a more efficient tax picture.
High earners can also combine a Dependent Care FSA with other tax-efficient strategies. For instance, using the FSA to cover a portion of childcare expenses, along with the Child and Dependent Care Tax Credit, can yield greater total savings for additional costs beyond the FSA limit.
It is also worth coordinating FSA elections with a spouse’s employer benefits to ensure the household maximizes available opportunities without exceeding contribution limits.
Alternatives to a Dependent Care FSA for High-Income Earners
For high-income earners with maxed-out Dependent Care FSAs or for those who find its limits too restrictive, other strategies may help better manage childcare expenses while optimizing tax efficiency.
While these options vary in eligibility and complexity, each offers potential savings or flexibility that can complement—or even replace—an FSA in your overall financial plan.
- Child and Dependent Care Tax Credit. This federal tax credit allows you to claim a percentage of eligible childcare expenses, up to $3,000 for one dependent or $6,000 for two or more. Although the credit rate drops to 20% for higher-income earners, it can still offset costs beyond what your FSA covers, particularly for families spending more than $5,000 annually on care.
- Employer-provided childcare benefits. Some employers offer direct childcare subsidies, on-site daycare or backup care programs as part of their benefits package. These benefits may not reduce your taxable income in the same way an FSA does, but they can significantly lower out-of-pocket expenses while providing convenience and reliability for working parents.
- Dependent Care Assistance Programs (DCAPs). Larger companies sometimes structure broader Dependent Care Assistance Programs to include FSAs, in addition to other forms of employer-paid support. High earners should review their benefits guide or HR portal to see if additional reimbursement or subsidies are available beyond the standard FSA limits.
- Tax-efficient investment withdrawals. For families with sizable investment portfolios, carefully timing capital gains distributions and using tax-advantaged withdrawals from accounts like a Health Savings Account (HSA) for medical-related care can help offset childcare costs indirectly. A financial advisor can guide you through minimizing the tax impact of these withdrawals.
- State and local tax credits. Some states offer their own dependent care tax credits, often mirroring the federal program but with different income thresholds or benefit amounts. High-income families may find that these state-level credits provide additional relief, even if the federal benefit phases out.
While none of these options fully replace the simplicity or predictability of a Dependent Care FSA, you can deliver stronger financial results by combining several strategies. High-income earners benefit most from a coordinated plan that aligns tax benefits and employer programs with investment strategies.
It is best to enlist the help of a financial advisor who can tailor their expert recommendations to family income and needs.
Bottom Line
For high-income earners, a Dependent Care FSA may not move the needle dramatically, but it remains a smart, tax-efficient way to manage the childcare expenses you’re already paying. Even with its $7,500 contribution cap and use-it-or-lose-it rules, the ability to reduce taxable income offers guaranteed savings with minimal effort. When combined with other strategies, like the Child and Dependent Care Tax Credit, employer childcare benefits or state-level programs, it can form part of a broader financial plan that keeps more of your income working for you.
Tips for Tax Planning
- A financial advisor can help with all of your long-term financial planning needs, including what to do about your impending tax bill. They can find the right solution for you and your assets. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Wondering what you might be paying in income tax next year? Consider using an income tax calculator to input your information and see what you might have to pay before proper planning.
Photo credit: ©iStock.com/AndreyPopov, ©iStock.com/BartekSzewczyk, ©iStock.com/Jacob Wackerhausen
Read the full article here
