Making the Most of Child-Care Tax Breaks
A dependent-care flexible spending account can be a great way to save for expenses while lowering your tax bill.
Question: My wife and I are getting ready to pay for summer camp for our two kids, which we usually do with money I set aside in a work-sponsored flexible spending account for child care. But I know there's also a federal tax credit for child care. How do I know which one is the best deal for us, and can I use both?
Answer: As you already know, child care can be among the most expensive aspects of parenthood. The cost of day care alone can easily exceed $1,000 a month, draining resources from the family budget. Fortunately, dependent-care FSAs and the child- and dependent-care tax credit can help ease the pain of these high costs for parents who must pay for child care in order to work, look for work, or attend classes full time.
There are a variety of eligibility qualifications for each tax break (which can be found here), but care generally must be for the benefit of a child who is younger than 13 or a spouse or dependent who lives with you and is unable to care for him or herself, such as elderly parents. Eligible expenses can include everything from preschool tuition and day camp (though not overnight camp) for the kids to in-home care or adult day care for the elderly. If married and filing jointly, both parents must have earned income (unless one is a student or disabled). Married couples filing separately generally cannot take the tax credit but can still open a dependent-care FSA.
FSA Makes Sense at Higher Incomes
Assuming you meet these criteria, the next question involves income level (this is assuming your employer offers a dependent-care FSA--not all do). A dependent-care FSA allows working single parents and married parents filing jointly to set aside up to $5,000 (or $2,500 each for married parents filing separately) of pretax income to cover qualified child- and dependent-care expenses. It works very much the way a flexible spending account for health care or a 401(k) does, with the money deducted from your gross income. That, in turn, reduces the amount of your salary subject to federal and (in some cases) state income taxes.
There is no income limit on eligibility, so this reduction in taxable income is particularly valuable for those in higher tax brackets. For example, a worker who puts $5,000 into a dependent-care FSA out of an annual salary of $100,000, and who is in the 28% bracket, would save $1,782 in taxes. (This also includes not having to pay 6.20% in payroll taxes for Social Security and 1.45% for Medicare, for a total tax savings of 35.65%; the current payroll tax cut, which lowered the Social Security tax for workers to 4.2%, expires next year.)
Tax Credit has Greater Benefit at Lower Incomes
The child and dependent-care tax credit (which requires this tax form), by contrast, will be less beneficial to high earners. Unlike an FSA, which lowers the worker's amount of taxable income, the credit is a dollar-for-dollar reduction in his or her tax bill. It allows individuals and families with child- and dependent-care expenses to take a tax credit of up to 35% of the amount they've spent. Eligible expenses are limited to $3,000 for a single child or dependent or $6,000 for two or more children or dependents.
The catch is that that percentage decreases based on adjusted gross income, to a bottom rate of 20% for taxpayers making more than $43,000. A taxpayer earning $15,000 per year and spending $5,000 on eligible expenses would be able to take a credit equal to 35% of that amount--$1,750--whereas our $100,000 earner from the previous example would only be able to claim a credit equal to 20% of the $5,000 in expenses, for a $1,000 credit. For those in the 25% tax bracket or above, the FSA option is usually the better choice, but the only way to be sure is to run the numbers yourself or consult a tax professional.
Taking All the Credit
So what about using both a dependent-care FSA and the tax credit? That is an option, but money contributed to the FSA must be deducted from the amount you can claim for the tax credit. So, if your employer caps the amount you can put in an FSA at $2,000 and you spent $3,000 for care of one child or dependent, you could still claim the extra $1,000 toward a tax credit. If you have two children or dependents and spent $6,000, you'd have $4,000 to claim toward the tax credit. Even if you are able to max out your FSA at $5,000 but you have two eligible dependents, you could still potentially apply another $1,000 toward the federal tax credit. In any case, however, remember that you may not claim the same expense under both an FSA and the dependent-care credit.
Things to Keep in Mind
One big caveat with a dependent-care FSA is that, like an FSA for medical expenses, it is "use it or lose it." Any unused funds in the FSA at the end of the year are forfeited. So be careful when deciding how much to contribute.
Whether you're using a dependent-care FSA or taking the tax credit, bear in mind that the amount eligible for a deduction cannot exceed the lower of the two incomes in a joint filing, or that of the individual in a single filing. The exception to this is if one spouse is a full-time student or is unable to care for him or herself, in which case a special formula applies. Also, remember to keep all receipts related to child- and dependent-care costs for tax purposes or for reimbursement from the FSA plan.
Knowing whether to use the FSA, the tax credit, or a combination of the two could mean hundreds of dollars in your pocket each year. And with the high price of raising a family, every little bit helps.
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