Editor’s Note: We are SO LUCKY to have a CPA join the SMB team! Janet will be our resident expert on all things numbers, and her first post is just in time to help boost our savings this tax season.
Child care is often a challenge for working parents. Quality care for our little ones doesn’t come cheap! Fortunately, there are ways to maximize the tax benefits. Here is a quick look at what you need to know to get the most from your daycare dollars.
First, if your employer offers a dependent care flexible-spending account (FSA) as a part of your benefits package, use it! This type of plan authorizes your employer to set aside a specified amount of your wages each pay period. Rather than using the FSA money to pay for child care expenses directly, you pay those costs out-of-pocket and then apply for reimbursement. Once you’ve paid for expenses that qualify, you submit a claim form along with proof of payment and your employer reimburses you for that amount. The main benefit of the FSA is that the money is set aside pre-tax, thus reducing the amount of your income subject to federal and state income tax as well as social security and medicare tax (FICA). For a family in the 28% federal tax bracket, this income reduction means saving $280 in federal taxes for every $1,000 spent on dependent care with an FSA.
The IRS limits the amount you can set aside for dependent care to $5,000 per year. If you are divorced, only the parent who has custody of the child(ren) can use the FSA funds for child care. If you are married, both parents must work and earn income to qualify for reimbursement. Qualified expenses include daycare, a nanny, summer day camps, and before- and after-school care. Education expenses (i.e. kindergarten, preschool, summer school, and private school tuition) do not qualify.
If your employer doesn’t offer a dependent care FSA, you can take advantage of the Child and Dependent Care Tax Credit (CDCTC). The CDCTC allows working parents to to claim a tax credit on up to $3,000 in expenses for one child or $6,000 in expenses for two or more children. Calculating the credit requires taking your actual expenses or the maximum expense, whichever is less, and multiplying it by a percentage from 35% to 20%, based on your gross income. For families with $43,000 or more in gross income the credit is 20% of of the maximum, so $600 for one child or $1,200 for two or more children.
So which is better: the FSA or the CDCTC? I’ll use my family as an example.
We are in the 25% federal tax bracket and 3% for Arizona state income taxes. I also pay the combined FICA tax rate of 7.65%. We have one son and our expenses for child care were $6,800 last year, so I set aside the maximum of $5,000 into my FSA.
Tax Savings: $1,250 on our federal income tax, $383 reduction in FICA taxes, $150 on our Arizona state income tax. Total savings: $1,783.
What if I didn’t set aside the money in my FSA? We’d still be in the same 25% tax bracket, but I would claim the maximum CDCTC allowable based upon our income. Our family’s gross income is more than $43,000, so the maximum credit available to us would be 20% of the $3,000 limit for one child.
Tax Savings: $600 on our federal income tax, no savings on social security and medicare taxes, no savings on our Arizona state income tax.
If you have two or more children and your daycare expenses exceed $5,000, you can take advantage of both the FSA and the dependent care credit. You’ll set aside $5,000 in pre-tax money from your FSA and claim the dependent care credit on up to $1,000 in additional expenses.
Calculating the credit may seem confusing, but if you hire a professional or use tax prep software, most of the work will be done for you. With the tax savings available, the child care credit is definitely one worth calculating.