Child care credit / dependent care flexible spending account
For an expense to qualify for the child 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 of your child (or other dependent) who is either under 13 or handicapped. The cost of household services can also qualify, e.g., domestic help, as long as
the cost at least in part goes towards the care of the individual.
The typical expenses that qualify are payments to a day-care center, "nanny" or nursery school. "Sleep-away" camp does not qualify. The cost of first grade or
above doesn't qualify because it's primarily an education expense and not a "care" expense. Although, surprisingly, the rules on kindergartens are not as clearly
defined. Apparently, if the school offers a program similar to a nursery school's (more play ("care") than education) it can qualify. If it offers more of an educational
program, it may not.
To claim the credit, you and your spouse must file a joint return. Further, you must provide the name, address, and Social Security number of the care-giver (or ID
number if it's a day care center or nursery school). A day care center must be in compliance with state and local regulations.
You also must include on the return the social security number of the child/children who receive the care. There cannot be a credit without it. 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 figure for whichever of you earns less.
Under this limitation, if one of you has no earned income, you won't be entitled to any credit. (However, special rules essentially remove this limitation for a spouse
who's a full-time student or disabled.)
Next, qualifying expenses for any year can't exceed $2,400 per year if you have one qualifying child, or $4,800 per year for two or more. In most cases, this limit
will set the ceiling for you. (Note: if your employer has a dependent care assistance program under which you receive benefits, excluded from gross income, these
limits ($2,400 or $4,800) 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 $28,000 or less, the
percentage will be higher, but never above 30%.)
Example: Lyle and Ellen both work and place their son in a day care center. Lyle earns $65,000, but Ellen earns only $6,000. They spend $8,500 on day care per
year. The first limitation discussed above limits the qualifying expenses to $6,000, Ellen's earned income. The second limits them further to $2,400. Twenty percent
of this amount is $480 and that would be their child care credit. (If the expenses were for two or more children, their credit would be $960 (20% of the $4,800
limit).)
Note that a credit reduces your tax bill dollar for dollar. That is, in the above example, Lyle and Ellen pay $480 less in taxes by virtue of the credit.
If your employer offers a dependent care flexible spending account (FSA), you may wish to consider participation in the FSA instead of taking the child care credit.
(You may not do both). 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.
Dependent care FSAs are generally more advantageous from a tax perspective than taking the tax credit. However, there's no substitute for doing an actual
comparison.
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 is not 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 taxable wage base for the year in which the contribution is made.
It should also be noted that depending upon the state in which a taxpayer resides, the taxpayer may also be afforded savings on state income tax by taking
advantage of the child care credit or your employer's dependent care flexible spending account.
Another advantage of an FSA over the child care credit is that, beginning in 1999, the child care credit is allowed only to the extent that your regular income tax
liability exceeds your tentative minimum tax (as computed for purposes of determining whether you are subject to the alternative minimum tax). The amount of your
tentative minimum tax does not affect your right to exclude amounts put into a 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 child care credit and dependent care flexible spending accounts for you. 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 child
care credit. If you have any questions or would like to discuss the area further, please feel free to contact our office.
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