Two tax breaks for child-care expenses
Working parents can save on their taxes through the child-care tax credit or by using a flexible spending account. Do the math to see which works better for you.
This post is by Bill Bischoff of MarketWatch.com.
You may have to pay child-care expenses for your kids so you can work. Thankfully, a federal income tax credit can help pay the bills. It’s available to all eligible parents regardless of income, although lower-income folks get bigger credits. Also, your employer might offer a child-care flexible spending account (FSA). When the FSA deal is available, it can offer even more tax savings than the credit.
Here’s what you need to know about both breaks.
The credit can only be claimed for child-care expenses so you can work. If you’re married and file jointly, you can generally claim the credit only if your spouse also works or goes to school full-time for at least five months during the year.
The credit is based on up to $3,000 of eligible expenses to care for one child under the age of 13, or up to $6,000 for two or more kids under 13. If your child turns 13 during the year, only expenses before the birthday count.
The credit rate ranges from a high of 35% of eligible expenses (limited to no more than $3,000 or $6,000 of expenses) to a low of 20%. The maximum 35% rate is available if your adjusted gross income (AGI) is $15,000 or lower. AGI is the number on the last line of page 1 of your Form 1040. It includes all taxable income items and certain write-offs, including alimony, deductible IRA contributions and moving expenses. The credit rate gradually drops to 20% as AGI approaches $43,000. Above $43,000, it sticks at 20%. In fact, that 20% rate applies even if you earn gazillions, because this is one break that, amazingly, is not phased out for high-income folks.
Example 1: You and your spouse both worked in 2012 and earned healthy salaries. You have one under-13 child and $5,000 of child-care expenses last year. Your credit for 2012 is $600 (20% of the $3,000 expense cap for one child). If you have two children under the age of 13 and $9,000 of expenses, your credit is $1,200 (20% of the $6,000 cap for two or more kids).
Eligible child-care expenses are limited to your earned income for the year. If you’re married and file jointly, expenses are limited to your spouse’s earned income or yours — whichever is lower.
If you work and your spouse is a full-time student for at least five months during the year, he or she is deemed to have $250 of imaginary earned income for each month (or part of a month) of full-time school. If you have two or more kids, the imaginary earned income is $500 for each month (or part of a month). For any given month, only one spouse can take advantage of this special rule for students. If you’re unmarried, it’s completely off the table.
Example 2: In 2012, you worked full-time and earned a $75,000 salary. Your wife was a full-time student for all or part of nine months in 2012 and had no actual earned income. You have two children under the age of 13 and $10,000 of child-care expenses for the time your wife went to school. Under the special rule for students, your wife is deemed to have $4,500 of imaginary earned income for 2012 ($500 times nine months). Your joint-return credit is $900 (20% of the $4,500 expense cap based on your wife’s $4,500 of imaginary earned income).
Child-care flexible spending account
Many companies have FSA plans that reimburse employees for expenses to care for children under the age of 13. To receive tax-free reimbursements, the expenses must be necessary for you to work. If you’re a married joint-filer, the expenses must be necessary for both you and your spouse to work (or for one to work while the other attends school full-time for at least five months).
Money to fund the FSA is withheld from your paychecks and is free of federal income, Social Security and Medicare taxes as long as it’s used to cover eligible child-care expenses. So this arrangement allows you to pay expenses with pretax dollars, which puts extra cash in your pocket. The maximum annual contribution is $5,000. If you’re married and file jointly, the $5,000 cap represents a combined maximum for both you and your spouse. Beware: Don’t contribute more than you know you’ll use, because any leftover FSA balance goes back to your employer.
You can’t take advantage of both the credit and the tax-free FSA deal for the same child-care expenses, and any tax-free FSA reimbursements reduce your $3,000 or $6,000 expense cap for claiming the credit. Note: If you’re in the 25% federal tax bracket or higher, the FSA option almost always saves more taxes than the credit.
That’s because the FSA allows you to avoid federal income tax (at least 25%) as well as Social Security and Medicare taxes (usually 7.65%), while the tax savings from the credit will usually be only 20%.
To claim the child-care credit or benefit from tax-free child-care FSA reimbursements, you must include Form 2441 (Child and Dependent Care Expenses) with your Form 1040. Then claim the credit on Line 48 of your Form 1040.
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