Save Money with a Dependent Care Tax Credit and FSA

by Xin Lu on 1 February 2011 1 comment
Photo: Eric Fleming

If you pay for the care of a dependent, then you may be able to save several thousand dollars a year via a dependent care flexible spending account (FSA) or the Child and Dependent Care Credit. Here is a quick guide to how you can maximize your savings:

Eligible Expenses

The expenses you can claim are usually the same for dependent care FSAs and the Child and Dependent Credit: the amount you pay to someone other than your spouse for the care of a child or dependent. If you are claiming expenses for the care of a child, the child must be under 13 years old. If you are not claiming a child, then the person you are caring for must qualify as an exemption on your tax return. Basically, your dependent must be unable to take care of himself or herself and have lived with you for at least half of the tax year. The expenses incurred also must be due to the need to work. You should keep detailed receipts of who provided the care and their tax identification numbers in order to back up the claim for your expenses. (See also: Tips for Choosing and Using a Babysitter)

The Dependent Care Flexible Spending Account

The dependent care flexible spending account is a common benefit at workplaces. It has a contribution limit of $5,000 per family, but the contribution is pre-tax, so you get to keep more of your wages. The money is taken out of your paychecks, and you can claim a reimbursement with a valid receipt from a caretaker or preschool. Because the FSA contribution is exempt from federal income tax, payroll taxes, and most state taxes, the maximum amount that families can save with a dependent care flexible spending account varies by their residence and tax brackets. For example, if you were a Californian with a 15% federal income tax, 9.55% state income tax, and a 7.65% payroll tax for a total tax burden of 32.2% and you contributed and spent the full $5,000, it works out to be a savings of about $1,610.

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The Child and Dependent Care Credit

The Child and Dependent Care Credit allows a 20% to 35% credit for up to $3,000 of expenses for one dependent. The percentage of credit varies by the income of the tax filer. If your family makes over $43,000 a year, then the credit would be 20% of the expenses you incurred. If you have more than one dependent, you can claim up to $6,000 of expenses. However, you need to subtract the amount you contributed to a dependent care FSA from the amount you claim. So if you already had $5,000 in your FSA and you had more than $6,000 of eligible expenses, you can only claim $1,000 in expenses for the purpose of the tax credit. This means that the maximum credit is $600 to $1,050 if you have one dependent and $1,200 to $2,100 if you have two or more dependents. The percentage of credit varies by the income of the tax filer. Currently the 35% credit is available to families making less than $15,000 a year, and then it gradually decreases to 20% for families making more than $43,000 a year. Since the median household income of the United States is around $46,000, most families will receive a 20% credit. The full details are in IRS Publication 503 (PDF).

How to Maximize Your Savings

What is the best choice for your family? Let's assume that you are in a family with the median household income of $46,000. Here are some possible scenarios:

Scenario 1: One Dependent 

If you have one dependent and spend at least $5,000 a year, then contributing to the FSA is definitely more advantageous. This is because the tax credit you would receive is only $600, but the amount you save via the FSA is at least $1,132.50 due to a federal income tax savings of 15% and a payroll tax savings of 7.65%. If you have a state tax that's waived on the contribution, then you would save more.

Scenario 2: Two or More Dependents

If you have two or more dependents and spend at least $6,000, then you should still contribute $5,000 to the FSA and claim $1,000 in expenses for the tax credit. This will yield an additional savings of $200 over the first scenario.

Scenario 3: No FSA Available

If your workplace doesn't offer the FSA, then you should take the full tax credit available to you. This is a tax credit that is often overlooked.

My conclusion is that for most families, it is best to contribute to the FSA first for your dependent care expenses. The percentage of taxes saved is usually higher than what the tax credit would give, but the tax credit does give a boost in savings to low-income families and families that spend above the FSA contribution limit. Either way, if you currently have dependent care expenses, you should definitely run the numbers and see how much you can save.

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It's good to remember, particularly for first-time parents or those who are in uncertain job situations that FSA's, while they can be tax-savers, are usually "use it or lose it." So, if you are just returning to work after a new baby and uncertain whether you will stick with daycare full-time for five months (about the time amount of time it would take to rack up a $5,000 bill, depending on where you live), you may stand to lose $5,000.