The IRS Code (Section 129) provides for "Dependent Care Assistance Plans" (DCAP), a method of employer-provided assistance for meeting the dependent care needs of employees. The most popular type of DCAP is the Dependent Care Flexible Spending Account offered through a flexible benefit plan. Employees can salary reduce on a pre-tax basis up to $5000 annually into a flexible spending account (FSA) for dependent care. The care must be for a child under age 13 or a disabled dependent meeting certain other requirements. Such salary reduction contributions are exempt from federal income tax, state income tax, and social security tax. Once the employee incurs an expense, the employee must submit an appropriate third-party receipt for reimbursement. Upon approval of the expense, a tax-free reimbursement is made to the employee.
Dependent Care Tax Credit
The IRS Code also provides for a "Dependent Care Tax Credit" for those paying for dependent care of a child under age 13, or for a spouse or dependent who cannot care for themselves. The expense must be necessary to allow the taxpayer (and spouse, if applicable) to work, seek work, or attend school.
To determine the available credit, a taxpayer can consider up to $3000/annually of child care expenses for one dependent, and a maximum of $6000/annually for 2 or more dependents. Depending on the taxpayer's adjusted gross income, the maximum credit (dollar-for-dollar offset of tax liability) is:
- 30% ($720 annually for 1 child) for those earning less than $10,000 annually...
- decreasing by 1% for each $2000 of additional annual income to...
- 20% ($480 annually for 1 child) for those earning over $28,000 annually.
In other words, the higher your earnings, the lower your tax credit.
Sounds great. What's the catch?
The IRS won't allow double-dipping. You can utilize either the Dependent Care FSA or take the Dependent Care Tax Credit, but you can not take a tax credit for expenses that have been reimbursed by the FSA.
So Which is Better for Me?
Generally speaking, those with less than a 15% tax bracket will be better served by the Dependent Care Tax Credit. IRS Publication 503 "Child and Dependent Care Expenses" provides full information about this tax credit and offers worksheets and aids for performing the calculations.
- If you are earning a moderate to high income, and particularly if you are filing taxes as "Married, Filing Jointly" (combining incomes with a spouse), the Dependent Care FSA is probably more advantageous. Reasons: Your tax bracket is probably higher than 15%, the threshold generally regarded as the dividing point between the Dependent Care Tax Credit (best for those earning LESS) and the Dependent Care FSA (best for those earning MORE).
- Logically, if you have 1 child, the $5000 available through the Dependent Care FSA is probably more generous than the credit arising from the $3000 limit imposed by the Dependent Care Tax Credit. (See section on Dependent Care Tax Credit, above.)
- Finally, the FSA saves not only income taxes (federal and state), but social security taxes as well. There are no social security tax savings offered by the Dependent Care Tax Credit. (Note: Your social security benefits could be slightly reduced by paying less social security taxes.)
Some assistance is provided by the IRS Publication 503 "Child and Dependent Care Expenses", which provides full information about the tax credit and offers worksheets and aids for performing the calculation.
One additional note: If you have more than one qualifying dependent and qualifying expenses in excess of $5,000, it may be possible to be reimbursed the maximum amount of $5,000 through the FSA and take a Dependent Care Tax Credit based on excess expenses up to $1,000.
A more precise analysis can be made by your tax advisor. We recommend that in all matters regarding legal and tax counsel, the services of qualified legal and tax counsel be sought.
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