Dependent Care – Tax Credit and Flexible Spending Account

If you pay for care for a dependent and have earned income, you should consider the benefits of the dependent care credit and dependent care flexible spending account.

For an expense to qualify for the dependent care credit, it must be an "employment-related" expense, i.e., it must enable you and your spouse to work, and it must be for the care an eligible dependent, who's under 13, lives in your home for over half the year, and doesn't provide over half of his or her own support for the year. It could also be for the care of your spouse or dependent who's handicapped and lives with you for over half the year.

The typical expenses that qualify for the credit are payments to a day-care center, nanny, or nursery school. Sleep-away camp doesn't qualify. The cost of first grade or above doesn't qualify. The rules on kindergartens aren't clearly defined.

To claim the credit, you and your spouse must file a joint return. You must provide the care-giver's name, address, and social security number (or tax ID number if it's a day-care center or nursery school).

You also must include on the return the social security number of the children who receive the care. Omission of the social security numbers while still claiming the credit will result in a summary assessment of tax liability against you.

Several limits apply. First, qualifying expenses are limited to the income you or your spouse earns from work, using the amount for whoever of the two earns less. If one of you has no earned income, you won't be entitled to any credit. However, under certain conditions, when one spouse has no actual earned income and is a full-time student or disabled, that spouse is considered to have monthly income of $250 (if the couple has one qualifying child) or $500 (two or more qualifying children).

Next, qualifying expenses can't exceed $3,000 per year if you have one qualifying child, or $6,000 per year for two or more. In most cases, this dollar limit will set the ceiling for you. Note that if your employer has a dependent care assistance program under which you receive benefits excluded from gross income, the dollar limits ($3,000 or $6,000) are reduced by the excludable amounts you receive.

Finally, the credit will be computed as a percentage of your qualifying expenses-in most cases, 20%. (If your joint adjusted gross income is $43,000 or less, the percentage will be higher, but not above 35%.)

Example: Lyle and Ellen both work, and place their son in a day-care center. Lyle earns $114,000 but Ellen earns only $6,000. They spend $8,500 on day care. The earned income limitation discussed above limits the qualifying expenses to $6,000, Ellen's earned income. The dollar limitation limits them further to $3,000. Twenty percent of this amount is $600 and that's their dependent care credit. (If the expenses were for two or more children, their credit would be $1,200, 20% of the $6,000 dollar limit.)

Note that a credit reduces your tax bill dollar for dollar. Thus, in the above example, Lyle and Ellen pay $600 less in taxes by virtue of the credit.

If your employer offers a dependent care flexible spending account (FSA), you may wish to consider participating in the FSA instead of taking the dependent care credit. Under a dependent care FSA, you may contribute up to $5,000 on a pre-tax basis. The money is withheld by your employer from your paycheck and placed with a plan administrator in a non-interest bearing account. As you incur dependent care costs, you submit a statement with the plan administrator substantiating the cost, and receive reimbursement.

If your marginal tax rate is more than 15%, participating in the FSA is more advantageous than taking the dependent care credit. This is because the exclusion from income under the FSA gives a tax benefit at your highest tax rate, while the credit rate for taxpayers with AGI over $43,000 is limited to 20%.

In addition to a federal income tax savings, participating in a dependent care FSA will result in savings on FICA (social security) taxes, because the amount contributed to the FSA isn't included in wages for FICA purposes. Consequently, you may save up to 7.65% of the amount contributed to the dependent care FSA, depending upon your income and the FICA tax wage base for the year in which the contribution is made.

If your marginal rate is 15% or less, taking the credit may be more advantageous than participating in the FSA. In making the choice, you must consider the effect of the earned income credit, the refundable child tax credit, and Social Security tax.

It should also be noted that residents of some states can save on their state income tax by taking advantage of the dependent care credit or an employer's dependent care FSA.

There are three drawbacks to dependent care FSAs. First, money is deposited in an FSA on a "use it or lose it" basis. If you don't incur dependent care expenses that equal or exceed the amount you deposit in the FSA, you forfeit the surplus. In addition, once you elect to participate in an FSA, and elect the amount withheld, with limited exceptions, you may not change your election. Finally, it often takes several weeks to receive reimbursement for the expenses submitted.

We hope the above clarifies the essential elements of the dependent care credit and dependent care FSAs. If your employer offers a dependent care FSA, we would be more than happy to prepare a comparison of the savings the FSA would afford you with the tax savings afforded by the dependent care credit.

If you have any questions or would like to discuss the subject further, please contact us.