EGTRRA Offers Dependent Care an Unexpected Benefit

November 5, 2002 ( - With open enrollment season already underway for many employers, workers may be getting conflicting advice about the best approach on dependent care.

The issue for many workers is whether to use the Dependent Care Spending Account (DCSA) or whether to use the improved 2003 Dependent Care Tax Credit.    A growing number of employers now sponsor a Dependent Care Spending Account (DCSA) for their employees as a way to save employee payroll taxes on their dependent care expenses.   Employee participation in the DCSA has typically been low, around 1% to 3% of eligible employees, according to Joe Lineberry, a senior vice-president with Aon Consulting.  

Employers have continued to offer the DCSA in spite of those rates since the relatively high contribution per employee allows the employer to save enough FICA taxes to cover the administrative expenses of offering the DCSA.   In addition, it provides a family-friendly benefit at minimal cost to the employer.  

Under the 2002 tax rules, it was generally felt that an employee whose adjusted gross income was less than approximately $24,000 would, in most cases, be better off claiming the Dependent Care Tax Credit.   However, the Economic Growth Tax Relief and Recovery Act (EGTRRA) enhanced the Dependent Care Tax Credit  for 2003, and slightly lowered the federal income tax rates.   That combination has led some advisors to suggest that the DCSA will be even less useful (compared to the Dependent Care Tax Credit) for many employees in 2003 and later.   These advisors have suggested that only employees with family income of at least $39,000 will be better off with the DCSA.

Income Reduction

However, that’s just part of the story, according to Lineberry.   EGTRRA also made a less-publicized change in the definition of earned income, which actually makes the DCSA more favorable for most parents eligible for the Earned Income Tax Credit (EITC).   This change, which was effective in 2002, allows workers to use their DCSA contributions (and other pre-tax contributions) to reduce their earned income for EITC purposes – in the same way that pre-tax contributions to the DCSA or 401(k) plan reduce one’s taxable pay on the W-2.   As a result, eligible parents who salary reduce their contributions to the DCSA actually increase their EITC, according to Lineberry. (And it’s not just DCSA salary reductions that can enhance this credit; it’s any sort of salary reduction, including 401(k) and before-tax medical premiums.)

By using the DCSA to reduce their earned income, employees with one dependent child reduce their taxes by an extra 16% of their pre-tax contribution if they earn under approximately $30,000.   If they have more than one dependent child, using a DCSA reduces their taxes even more, by 21% of the pre-tax contribution to the DCSA as long as the family income is under approximately $34,000.These EITC tax savings are in addition to the federal income and FICA tax savings, which were already available under the tax law.    Lineberry notes that, in most cases, this is enough to make the DCSA the tax-preferred alternative for parents with family income of at least $14,000 but below $30,000-$34,000.

Out of Focus

By focusing only on the expanded dependent tax credit and new tax rates, some financial advisors have incorrectly concluded that DCSAs are a less favorable alternative in 2003.   However, when one also takes into account the impact of expanded access to the EITC, thanks to the salary reduction benefits of the DCSA, the results can be quite different.   Parents earning between about $14,000 and   $30,000-$34,000 in family income, as well as those earning above $39,000, will typically be better off with the DCSA.

These misunderstandings can have a significant impact on the employer-sponsored plans.   When employers offer a DCSA, they must pass a 55% discrimination test, which is difficult to pass if a large proportion of highly compensated employees use the DCSA but nonhighly compensated employees do not use the DCSA.   If employers fail the test, they have to cut back contributions by highly paid participants during the year, or worse, tax the highly compensated on the entire DCSA contribution after the year is over.

According to Aon, the above analysis shows that more lower-paid employees will be better off with the DCSA than in the past.   Increased participation by those employees may then make it easier for employers to pass the 55% DCSA discrimination test.  However, Lineberry cautions that  this analysis does not factor in the impact of state income taxes and state dependent care credits on the employees’ decision process.   Consequently, employees should consult their tax advisors for help with state income tax laws, since they vary significantly.  

In order to help workers make the best determination for their individual situation, employers may want to consider the following chart .