Tax Center / Marriage & Family
Child Care Credit and FSAs
By Roy Lewis
Many of you work for employers that offer Flexible Spending Accounts (FSAs), sometimes called "cafeteria plans." Many of you also have young children that may qualify for the Child Care Credit. There is an important relationship between the two that I would like to review with you.
First, let's briefly look at the Child Care Credit. For an expense to qualify for this credit, it must be an "employment-related" expense. That is, it must enable both you and your spouse to work, and it must be for the care of your child (or other dependent) who is either under 13 years old or handicapped. Paying the next door neighbor to baby-sit while you and your spouse go out for dinner and a movie does not qualify.
Typical qualifying expenses are payments to a daycare center, nanny, or nursery school. Sleep-away and sports camps generally don't qualify. The cost of first grade or higher doesn't qualify because that is primarily an education expense. Surprisingly, the rules on kindergartens aren't clearly defined. Apparently, if the school offers a program similar to that of a nursery school (more "care" than education) it can qualify. If it offers more of an educational program, it might not.
How do you know if your childcare qualifies?
To claim the credit, you and your spouse must file a joint return and complete IRS Form 2441. You must provide the name, address, and Social Security number of the caregiver (or ID number if it's a daycare center or nursery school). If it is a daycare center, it must be in compliance with state and local regulations. You also must include on the return the Social Security numbers of your children who receive the care. There's no credit without it. Omitting 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 whomever earns less. If one of you has no earned income, you will not be entitled to any credit. (However, special rules essentially remove this limitation for a spouse who is a full-time student or disabled.)
Next, qualifying expenses for any year can't exceed $2,400 per year for one child, or $4,800 per year for two or more. (Note that 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: Jack and Jill both work and place their son in a daycare center. Jack earns $65,000 and Jill earns $6,000. They spend $8,500 on daycare. The first limitation discussed above limits the qualifying expenses to $6,000, which is Jill's earned income. The second limits them further to $2,400 (since there is only one child involved). Taking 20% of this amount gives us $480, which is their child care credit. If their expenses were for two or more children, their credit would be $960 (20% of the $4,800 limit).
Remember that a credit reduces your tax bill dollar-for-dollar. Therefore, in the above example, Jack and Jill will pay $480 less in taxes by virtue of the credit. Credits are always more valuable than deductions.
However, if your employer offers a dependent care flexible spending account (FSA), you might want to consider participating in the FSA instead of taking the child care credit. Under a dependent care FSA, you can contribute up to $5,000 per family on a pretax 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 to 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.
Example #2: Using the above example as a starting point, and assuming the maximum $5,000 contribution to a dependent care FSA, we would see the following: Jack and Jill's combined gross income ($71,000) reduced by the $5,000 contribution to the FSA is $66,000. Assuming a $7,200 standard deduction (for 1999, married filing jointly), and three $2,750 exemptions totaling $8,250 (one each for Jack, Jill, and their child), Jack and Jill have a taxable income of $50,550 ($66,000 - $7,200 - $8,250= $50,550).
The 1999 tax on $50,550 for married taxpayers filing jointly is $8,565 (using the tax rate schedule). The 1999 tax for taxable income on $55,550 (Jack and Jill's taxable income if they hadn't excluded $5,000 under the dependent care FSA) would be $9965. By using the FSA, Jack and Jill save $1,400 in federal income taxes as opposed to $480 by taking the child care credit.
In addition to a federal income tax savings, participating in a dependent care FSA may 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 on your income and the taxable wage base for the year in which the contribution is made. In the example above, Jack and Jill would save an additional $382.50 in FICA taxes by contributing to the FSA, as opposed to taking the child care credit directly.
And it can get even better: If you live in a state that imposes an income tax, it is possible that the contribution to your FSA will also be exempt from state income taxes, thereby reducing your tax liability even further.
But, all of the news is not good: there are four major 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. Second, once you elect to participate in an FSA and elect the amount withheld, with limited exceptions, you may not change your election. Third, it often takes several weeks to receive reimbursement for the expenses submitted. Fourth, if you don't otherwise qualify for the credit (such as only one spouse working), and you use the FSA option, you will be required to add your FSA contribution back into your income, thereby losing most of your tax savings.
So, it is important that you review your options and the benefits provided by your employer to determine what is best for you. To review these and other child care issues in greater detail, see IRS Form 2441 and the associated instructions. See IRS Publication 503 for an additional discussion of the relationship between FSAs and the Child Care Credit.