Tax Relief for Child Care Expenses
The child care tax credit and dependent care accounts could save you thousands of dollars.
Every working parent knows that the cost of good childcare is expensive and ever increasing. Luckily, the federal government offers two tax breaks that can help defray some of these costs: the child care credit and dependent care accounts. If you pay for day care, preschool, or a nanny, it pays to learn about these two tax breaks — they could save you several thousand dollars.
The Child Care Credit
The child care credit provides a tax credit of 20% to 35% of the first $3,000 in child care costs you incur per child per year. The exact percentage is determined by your income level.
How does it work? Let’s say you and your husband pay a nanny $10,000 to care for your two children. You earn $80,000 that year which entitles you to a 20% credit. Your child care credit would be based on $6,000 ($3,000 per child). The maximum you could write off would be $1,200 ($6,000 x 20%).
Do your earnings limit how much can you claim? Notably, the total amount of your child care credit cannot exceed your earned income for the year, or that of your spouse.
Going back to the prior example, let’s say you and your husband pay a nanny $10,000 to care for your two children. You earn $80,000 that year, but your husband, who is writing a novel, earns only $900. Even though you would otherwise be entitled to write off $1,200 ($6,000 x 20%), because your husband earned only $900, you could only claim a child care credit of $900.
There are two exceptions to this rule:
- The government will waive this requirement if you or your spouse suffers from severe physical or mental limitations that interfere with the ability to work or study.
- Full-time students that don’t earn any income can still claim a $250 credit for one child and $500 for more than one child.
How to claim the child care credit. Claiming the child care credit is easy. Keep your child care expense receipts for the year and then input the appropriate information onto your tax return. For instructions on how to complete the necessary tax forms, visit the IRS’s website at www.irs.gov and get IRS Publication 503, Child and Dependent Care Expenses.
Dependent Care Accounts
A dependent care account is like the 401(k) plan of the child care world. Through your employer, you set aside pretax dollars that you can access to pay your nanny, day care, or preschool bills during the year. All of the money you contribute to the account is exempt from federal taxes. Not all employers offer dependent care accounts, and you can’t set one up on your own.
How much can you contribute? Federal law sets limits on the amount you can contribute. Regardless of how many children they have, 2011 married couples filing jointly can contribute a maximum of $5,000 to a dependent care account. Single people or married couples filing separately can contribute up to $2,500. Your employer can set an amount lower than the federal maximum (say $2,000).
Use it or lose it. When determining your annual contribution to a dependent care account, be conservative. If you have extra money in the dependent care account at the end of the year, you lose it.
Do your earnings limit how much can you claim? The amount you can use from your dependent care account is limited by your earned income. You cannot claim more than your earned income or your spouse’s earned income, whichever is less. So, if you or your spouse is not working, you cannot use any of the money in the dependent care account.
Here’s an example of how this works. Let’s say you contribute $5,000 to a dependent care account for your child. You spend $8,000 on child care that year. Your husband is laid off at the beginning of the year and earns only $3,000 for the entire year. Even though you have $5,000 in your dependent care account and incurred $8,000 in child care expenses, you can only use $3,000 of those pretax dollars (the amount your husband earned). The remaining $2,000 in the account is lost.
There is one exception to this rule: if you or your spouse is a full-time student who makes zero income, you can still pay for up to $250 of your child care expenses ($500 for more than one child) using pretax dollars through a dependent care account.
Enrolling in and getting reimbursed from a dependent care account. If your employer sponsors a dependent care account, you’ll be able to enroll during your general benefits enrollment period. At that point, you decide how much money to contribute for the year (you can’t change this amount during the year).
To access money from your dependent care account, first incur the child care expense, then submit a form and the receipt to your employer or to the fund administrator. Consult your employee benefits manual or check with your human resources administrator for more information on your company’s reimbursement policy.
You will also have to input this information onto your tax return. For instructions on how to complete the necessary tax forms, visit the IRS’s website at www.irs.gov and get IRS Publication 503, Child and Dependent Care Expenses.
If you are eligible for both the child care credit and a dependent care account, you can opt to use one or both.
Choosing one. Usually, which child care tax break is best for you depends on your tax bracket. A good rule of thumb is to opt for an employment-sponsored dependent care account if you are in the 28% tax bracket or higher. If you’re unsure which will save you more money, ask a tax professional to run the numbers for you.
Using both. You can use both the child care credit and a dependent care account, but the money you contribute to your dependent care account will be subtracted from the maximum amount of child care expenses you can claim under the child care credit.
Here’s an example. Let’s say you earn more than $100,000 one year and you have one child. You contribute $2,000 to an employer-sponsored dependent care account. Without a dependent care account, you could claim a child care credit of 20% of $3,000 (amounting to $600). Instead, the dependent care contribution is subtracted from the child care credit ($3,000 – $2,000 = $1,000) allowing you to claim a child care credit of 20% of $1,000 (amounting to $200).
Who is Eligible for Child Care Tax Breaks?
You must meet the following requirements to be eligible for either the child care credit or a dependent care account:
- your child must be your biological, adopted, step, or foster child
- your child must live with you for more than half the year (time away from home for school or traveling counts)
- your child must be younger than 13 or permanently and totally disabled
- you must pay more than half the cost of keeping up a home in which you and your child live during the year (if your child has a trust fund or other income, the trust cannot provide more than half the support)
- you (and your spouse, if you are married) must work, look for work, or be a full-time student (single parents qualify if they are working or attending school full time, even if the child’s other parent is not), and
- you (and your spouse, if you are married) must have earned income for the year.
In addition to the above, your child care expenses must meet all of the following criteria:
- your child care provider must be someone whom you can’t claim as a dependent — this may include a licensed day care provider, preschool, or on-the-books nanny but can’t include anyone you pay under the table
- you must have used the child care to enable you to work, look for work, or attend school full time (for example, you cannot claim a credit for babysitter costs incurred to run errands or go out on Saturday night), and
- the payments must have been for child care only, not for items such as food, lodging, clothing, education, and entertainment. (Expenses for household services, such as housekeeping, qualify if they are at least partly for the well-being and protection of your child.)
Note that you don’t have to engage in comparison shopping and select the least costly child care option out there. Your expenses qualify even if there are less expensive or no-cost alternatives available to you.