Tax Relief for Child Care Expenses

Every working parent knows that the cost of good child care 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 and Dependent Care Tax Credit

The child care credit is a tax credit based on your childcare expenses. Under the regular rules, the maximum credit is 35% of childcare expenses up to $3,000 for one child, or $6,000 for two or more. However, for 2021 only, the maximum credit is 50% of childcare expenses up to $8,000 for one child and $16,000 for two or more. The exact percentage is determined by your income level.

Ordinarily, this credit is nonrefundable--it cannot exceed your tax liability for the year. However, for 2021 only, it is fully refundable--the IRS pays you the full amount as a tax refund even if you owe no taxes. This greatly benefits lower income taxpayers who pay little or no income tax.

Note that this credit is separate from the child tax credit, which anyone with a minor dependent child can qualify for. The child and dependent care credit is available only if you hire childcare providers.

How does it work?

Let's say you and your husband pay a nanny $10,000 to care for your two children. You earn $200,000 that year which entitles you to a 20% credit. Your child care credit would be based on $6,000. The maximum you could write off would be $1,200 ($6,000 x 20%). For 2021 only, you'd be entitled to a 50% credit based on $16,000--a maximum $8,000 credit.

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 $200,000 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.

However, there are two exceptions to this rule:

• The first exception applies if you or your spouse was disabled for all or part of the year—that is, not physically or mentally capable of self care.
• The other exception is if you or your spouse was a full-time student for at least part of five months during the year (this does not include on-the-job training courses, correspondence schools, or schools offering courses only through the Internet).

If either exception applies, you may treat the nonearning spouse as earning $250 in earned income per month (or part of a month) that he or she was disabled or a full-time student during the year ($500 per month if you have more than one child). Thus, if one of these exceptions applies, the nonearning spouse could be deemed to have up to $3,000 in earned income, or $6,000 if you have 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. You must file IRS Form 2441, Child and Dependent Care Expenses with 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 use 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. If you're a self-employed sole proprietor, you can set up an account and treat yourself as the employee.

How much can you contribute?

Federal law sets limits on the amount you can contribute. Regardless of how many children they have, married couples filing jointly ordinarily 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. However, for 2021 only, these maximums are $10,500 for married couples filing jointly and $5,250 for marrieds filing separately. Your employer can set an amount lower than the federal maximum (say $2,000).

Use it or lose it, or not

Under the regular tax rules, money left over in a dependent care account at the end of the year (plus 2.5 months) is lost. Thus, when determining your annual contribution to a dependent care account, it usually pays to be conservative.

However, there are special rules for 2020 and 2021. Your employer may allow the entire unused balance in a dependent care account at the end of 2020 can be carried forward into 2021, and any balance at the end of 2021 can be carried forward into 2022.

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.

However, there are two important exceptions to this rule. If you or your spouse make zero income because you or your spouse are (1) a full-time student, or (2) physically or mentally disabled, you may treat the nonworking spouse as earning $250 in earned income per month ($500 per month if you have more than one child). Thus, if one of these exceptions applies, the nonworking spouse could have up to $3,000 in earned income for the year for purposes of using your dependent care account ($6,000 if you have more than one child).

How to enroll and get reimbursed

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 Which Child Care Tax Break to Use

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 24% 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 have one child. You contribute $2,000 to an employer-sponsored dependent care account. Without a dependent care account, under the regular tax rules, 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).

For 2021 only, you could claim a child care credit of 50% of $8,000 (amounting to $4,000). If you made a $2,000 dependent care contribution, you can claim a child care credit of 50% of $6,000 (amounting to $3,000).

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 (if your child turns 13 during the year, you can only include those expenses you incur before his or her 13^th birthday)
• 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), and
• you (and your spouse, if you are married) must have earned income for the year (subject to the exceptions noted above).

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 report the name, address, and Social Security number or employer identification number of the care provider on your return; you can use IRS Form W-10, Dependent Care Provider's Identification and Certification, to request this information from the care provider.
• 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.

The IRS has an online questionnaire you can complete to determine if you qualify for the child and dependent care credit. Visit the Am I Eligible to Claim the Child and Dependent Care Credit? page at the IRS website.