Who loves paying for childcare?!?! Bueller? Bueller? It figures. No one. For many, it is a necessary fact of life, though. So, we might as well get the biggest bang for our tax buck as possible. The child and dependent care credit and dependent care flexible spending accounts are two ways to help offset the burdensome cost of childcare. While there are some similarities, there are some nuances to be aware of that could limit the tax efficiency of childcare expenses. The remainder of this post will give a background on these two benefits and explore some strategies to coordinate the use of both to maximize the tax benefits.
Child and dependent care credit
Single and married filing joint taxpayers can claim a 35% tax credit on up to $3,000 (for one qualifying individual) or $6,000 (for two or more qualifying individuals) of eligible expenses to assure the individual’s well-being and protection. You (and your spouse, if filing a joint return) must be working or looking for work to qualify for the credit. The credit can be reduced to 20% if adjusted gross income (AGI) is too high. While there are several classes of “qualifying individuals,” we are going to focus solely on dependent children younger than 13 when the care was provided. Care inside and outside of the house can qualify for the credit.
Expenses for care include expenses for a child in nursery school, preschool, or similar programs for children below kindergarten. Educational expenses for children in kindergarten or higher are not eligible expenses. Food, lodging, clothing, and entertainment are not considered eligible expenses. However, small amounts for these items can be included if they are incidental and cannot be separated from the cost of care.
This benefit is a credit which means it offsets taxpayers’ tax burden dollar for dollar. For example, a $600 credit (the reduced 20% of $3,000 eligible expenses for one individual) will reduce a taxpayer’s tax due by $600.
Dependent care flexible spending account
A dependent care flexible spending account’s tax treatment is similar to a healthcare flexible spending account. Contributions are made through pretax payroll deductions, and distributions are tax free when used for eligible expenses. These accounts are only available through employers and have a family maximum contribution limit of $5,000 even if each spouse has access to their own DCFSA. In comparison to the tax credit, the tax savings is whatever tax bracket the taxpayer is in. For example, a taxpayer in the 24 percent tax bracket saves $1,200 in taxes on a $5,000 contribution, and a taxpayer in the 32 percent tax bracket saves $1,600 (32 percent times $5,000).
Eligible expenses, qualifying individuals, and the work requirements are the same as the child and dependent care tax credit. Dependent care flexible spending accounts do not have an income requirement (other than not being allowed to contribute more than your earned income), however, and much like their FSA cousins, balances are use it or lose it.
Coordinating both benefits
Due to the no “double dipping” rules of each benefit, taxpayers should consider coordinating the two benefits to get maximum tax efficiency. Double dipping means the credit and DCFSA cannot be used for the same eligible expense. Let’s take a look at an example to see the impacts of coordinating the benefits.
Example 1: Jack and Jill both work and have access to a DCFSA at work. They are in the 22 percent tax bracket and have two children with total eligible expenses of $10,000 for the year. Being in the 22 percent tax bracket automatically puts them in the reduced 20 percent credit status. Their total eligible expenses exceed the credit and DCFSA amount which means they can use both benefits to receive favorable tax treatment on all of their expenses as opposed to only using the credit or DCFSA. Since they are in a bracket higher than reduced credit amount of 20 percent, they should first consider maxing out the DCFSA to get full tax benefits.
They would have a total tax savings of $2,080 (20 percent credit on maximum $6,000 expenses plus 22 percent savings on remainder of $4,000 of expenses) if they were to use the full credit before the DCFSA. On the other hand, they would save $2,100 of taxes (22 percent times $5,000 max DCFSA contribution plus 20 percent credit on remaining $5,000 of expenses) if they were to max out their DCFSA first and use the credit for the rest of their expenses.
While the tax savings between the two scenarios is not a huge amount in this example, the savings could be greater in other scenarios with taxpayers in higher tax brackets. Also, contributing to a DCFSA reduces a taxpayer’s AGI which could make a taxpayer eligible for other deductions and/or credits.
Generally, taxpayers in brackets higher than 20 percent should consider enrolling in a DCFSA first. Additionally, taxpayers wishing to reduce their AGI should contribute to a DCFSA, and taxpayers with childcare expenses greater than the credit limit should consider utilizing both strategies.
Conclusion
If the cost of childcare is a dark cloud, tax reduction may be a silver lining? Maybe? Before your next open enrollment period, you may want to speak to your tax preparer or financial advisor to see if you should enroll in a dependent care flexible spending account and how much you should contribute. If we have to pay for childcare, we might as well get the maximum tax benefit allowable.
Disclosure
Strategic Insights Financial Planning Group and LPL Financial do not provide tax advice or services. Please consult your tax advisor regarding your specific situation.