In an ideal world, many families would prefer to have only one parent work, leaving the other to care for young children. But it's increasingly tough to raise a family on a single salary, so many families send both parents out to work -- creating the additional trouble of finding good day care. Aside from a few major exceptions, including Target (NYSE:TGT) and Freddie Mac (NYSE:FRE), most companies don't provide day care on-site. And the financial benefits of a second paycheck can be eroded by the cost of day care.
If you choose to work and send your kids to day care, you may be able to get the IRS to cover some of the cost. Depending on what tax bracket you're in, and how much you pay for child care, you can save hundreds or even thousands of dollars on your taxes.
Child care and flex accounts
Many employers offer employees the ability to set aside money in a flexible spending account. While most people are familiar with flex accounts used for medical expenses, employers can also offer flexible spending accounts to cover child-care expenses. The advantage of using a child-care flex account is that you can make contributions to your account with pre-tax money, thereby avoiding having to pay income and payroll withholding taxes on the amount you contribute. When you withdraw money from your flex account to pay for your child-care expenses, you don't have to include it in your income. In essence, this converts what you pay for child care into a deduction. You can contribute as much as $5,000 each year to a child-care flex account.
The amount that a child-care flex account can save you depends on your tax bracket and your contributions. If you're in the 25% tax bracket and contribute the maximum amount of $5,000, you'll save $1,250 in income tax, plus an additional $382.50 on your payroll tax liability, for a combined savings of $1,632.50. In short, if you spend the maximum on child care each year, the IRS will cover about a third of the cost. Lower-income families, however, get less value from a flex account. If you're in the 10% tax bracket and pay $2,000 per year on child care, your total savings will only be about $350.
As with medical flex accounts, you have to be careful about how much you decide to contribute. You will lose any money that you contribute but don't use for child-care expenses by the end of each year. Therefore, you'll want to be certain about what you're going to pay for child care before you elect to set aside a certain amount into your flex account.
The child care credit
The tax laws also offer a credit to people with child-care expenses. The child-care credit allows you to reduce your taxes by a certain amount for every dollar you spend on child care, up to $3,000 for a single child or up to $6,000 for two or more children. The amount of the credit varies from 20% to 35% of what you pay for child care, depending on your gross income. Families with gross income of $43,000 or more get a 20% credit, while families earning $15,000 or less get the full 35% credit.
The amount that the child care credit can save you depends on what level of credit you qualify for, and how much you pay for child care. Using the examples above, a family of four in the 25% tax bracket paying $5,000 for child care would likely qualify for a credit of 20%, with a savings of $1,000. A family in the 10% bracket that makes $25,000 per year and spends $2,000 on child care would qualify for a 30% credit and save $600 in taxes.
You have to choose
Unfortunately, the IRS doesn't allow you to use the same child care expenses to both take advantage of a flex account and claim the child care credit. Therefore, the best thing to do is to run the numbers both ways and see which method saves you the most money. While every taxpayer's situation is different, one general rule is that the flex account deduction tends to create more savings for higher-income taxpayers, while the credit offers greater benefits to lower-income taxpayers. Obviously, if your employer doesn't offer a flexible spending account for child care, using the credit is better than nothing.
As a parent, it would be nice to find coverage for all of your child care expenses. Still, these tax incentives' savings can repay a significant fraction of day care costs. When you file your taxes, make sure you claim the tax benefits to which you're entitled, and use the method that puts the most money back in your pocket.
For more about ways you can save on your taxes, take a look at the Fool's Tax Center.