Child Care Credit vs. Dependent Care FSAs

by Thomas Astore
Tax Director

I was recently asked about how to qualify for the child care credit. At that time it became necessary to do a comparison of the child care credit and a dependent care flexible spending account. I thought it made sense to provide that same analysis to all of our clients and friends here.

For an expense to qualify for the 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, stepchild, or foster child, or your brother or sister or stepsibling (or a descendant of any of these), who is under 13, lives in your home for over half the year, and does not provide over half of his or her own support for the year. Or it can be for the care of your spouse or dependent who is handicapped and lives with you for over half the year. The cost of household services, e.g., domestic help, can also qualify as long as the cost at least in part goes towards the care of the individual.

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 because it’s primarily an education expense. Surprisingly, the rules on kindergartens aren’t clearly defined. Apparently, if the school offers a program similar to a nursery school’s (more play 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 care-giver’s name, address, and social security number (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 children who receive the care. There’s no 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 whoever of you earns less. Under this limitation, 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 that spouse 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). This means the income limitation is essentially removed for a spouse who’s a student or disabled.

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 $109,000 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 child 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 participation in the FSA instead of taking the child 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 child 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 adjusted gross income over $43,000 is limited to 20%.

Example: As in the example above, and assuming the maximum $5,000 contribution to a dependent care FSA, we find the following: Lyle and Ellen’s combined gross income ($115,000) reduced by the $5,000 contribution to the FSA is $110,000. Assuming an $11,400 standard deduction (for 2009, married filing jointly), and three $3,650 (for 2009) exemptions totaling $10,950, Lyle and Ellen have taxable income of $87,650 (($110,000 − $11,400) − $10,950), placing them in the 25% rate bracket. The tax on $87,650 for married taxpayers filing jointly for 2009 is $14,288 (using the tax rate schedule for 2009). The tax on $92,650 (Lyle and Ellen’s taxable income if they hadn’t excluded $5,000 under the dependent care FSA) would be $15,538 for 2008. By using the FSA, Lyle and Ellen save $1,250 in federal income taxes ($15,538 − $14,288). That’s $650 more than the $600 that they would save if they took the child care redit (see above).

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 you have more than one child who qualifies for the child care credit, so that the limit on expenses qualifying for the credit is $6,000, you can exclude the full $5,000 under the dependent care FSA and also claim a child care credit for $1,000 ($6,000 − $5,000) of expenses.

Example: If Lyle and Ellen had two qualifying children, their credit would be $1,200: 20% of the $6,000 dollar limit. Using the FSA would still be more advantageous, because they would have a $1,250 income tax savings from the exclusion, plus a $200 credit (20% × $1,000) for the additional $1,000 of qualified expenses ($6,000 dollar limit − $5,000 exclusion). They would also have a FICA tax saving if they used the FSA.

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 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 child care credit or an employer’s dependent care flexible spending account. In your situation as a resident of …

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.

I 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, I 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.


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