FSA or tax credit: Which is best to save on child care?

The sticker shock of daycare, babysitting, or a part-time child care program can cause many parents to panic. Regardless of income bracket, the fact is clear — child care is expensive.

The average annual cost of center-based infant care in the U.S. is nearly $16,000, according to a recent study by the Center for American Progress. This amount accounts for more than 16 percent of median married-couple family income — well above the Department of Health and Human Services’ (HHS) recommendation that child care should cost no more than 7 percent of household income.

The cost of child care has a significant impact on my family, as well as many of the families I work with as a financial planner. For some of us, child care expenses are equal to carrying a second mortgage month to month.

Financially preparing for child care

Families each plan for the financial stress of child care in their own way. Some parents choose to have one of them stay home full time with kids who aren’t in school yet because it actually costs less than having a dual income household that pays for full-time child care. Other families save in advance for child care expenses or look for lower-cost solutions, such as an in-home daycare, care from relatives, or a cobbled together schedule of drop-off programs, babysitters, and flexible work arrangements that allow partners to tag team and simultaneously work/care for their kids. Since the Covid-19 pandemic began, many families have also had to balance working at home with kids — a situation that is unlikely to change in the near future.

When my husband and I decided it was time to grow our family, we immediately started budgeting and saving for child care costs. We also got appropriate insurances in place, like term life insurance, while we were young and healthy to help save on costs. While this helped to offset the costs, we now have two little ones with full-time care, and the monthly expense adds up quickly! No matter which way you look at it, the cost of child care often sparks some tough financial decisions for a family.

Saving ahead of time helped put a dent in our upfront costs, but we also had to take a close look at how child care fit into our lives, and we use ongoing financial planning strategies to reduce the impact that those expenses have on our family’s budget.

Two of the strategies that many families might consider to help cover the cost of child care are using a Dependent Care Flexible Spending Account (FSA) and taking the Child Care or Dependent Care Tax Credit. Families can only opt to use one option, and you may need to crunch some numbers or speak with a financial advisor to figure out which option makes the most sense for your family. (Sometimes, an employee assistance program or other government aid may be available to help offset the cost of a monthly dependent care expense and other qualifying expenses.)

What is a Dependent Care FSA?

A Dependent Care FSA is an employer-sponsored, pre-tax account. You set up automatic deductions from your paychecks that are contributed to this account and are eligible to use those funds for qualifying child care expenses. An eligible dependent care expense under this can include preschool or nursery school. Other eligible expenses can include after school programs, work related child care, and day camps. This is eligible for dependents of an employee who is under the age of 13 or unable to care for themselves.

For the 2022 tax year, the maximum annual contribution was $5,000 per year, per household. Even if both you and your spouse have a Dependent Care FSA available through your individual employers, you can only contribute up to the annual maximum to one or both accounts.

Potential benefits of a Dependent Care FSA

There are many benefits to opening a Dependent Care FSA, including the possibility of saving money on your taxes.

• Your Dependent Care FSA is funded with pre-tax dollars. Much like a workplace retirement plan, this helps to reduce your total taxable income, meaning you may pay less overall taxes as a result.
• Dependent Care FSAs are also sheltered from the 7.65% Social Security and Medicare tax.
• In most cases, Dependent Care FSAs are sheltered from state taxes, as well.

How much can you expect in the way of tax savings? If you contribute the maximum $5,000 and fall into the 24% tax bracket, you’d be saving about $1,200 a year in federal income tax.

Potential drawbacks of a Dependent Care FSA

While Dependent Care FSAs have some obvious positives, there are a few drawbacks.

• FSAs are use-it-or-lose-it accounts. The funds you contribute don’t roll over from plan year to year. If you and your partner’s child care plans change, then you may be out that money.
• Not all employers offer Dependent Care FSA employee assistance program options.
• You’ll need to make sure all of your expenses qualify. This means tracking receipts, reimbursements, and other qualifying costs associated with your child care and making sure that all child care services you use are eligible for the funds in a Dependent Care FSA. For example, the cost of babysitters hired for care unrelated to your employer may not be an eligible expense for reimbursement.

Because FSAs don’t offer a year-to-year rollover, you’ll need to carefully budget for the amount of qualifying child care related expenses you actually have. If you overcontribute to the account and are left with unused funds, you’ll lose that money at the end of the year.

What is the Child Care Tax Credit?

Qualifying for the Child Care and Dependent Care Tax Credit requires that you:

• Have work-related expenses for child care. Basically, child care has to be necessary so that you can work. To prove this, the government requires that both parents provide proof of income. The exception to this rule is if a spouse is disabled or a full-time student.
• The care has to be for qualifying kids, 13 years old or under. A spouse or dependent who lives with the taxpayer for more than half the year and is either physically or mentally incapable of caring for themselves also qualifies.
• There is a limit to how much the credit is worth — up to 50% of qualifying child care costs for couples earning $125,000 or less. This percentage shrinks as your income increases over that amount.

In 2022, the Child Care and Dependent Care Tax Credit reverted to 35% of up to $3,000 in child care expenses for one child or $6,000 in child care expenses for two or more children, after a brief pandemic-related increase. As before, the percentage of child care expenses you are allowed to claim goes down as your income goes up. (Note: All facts and figures for the 2022 update to this post were verified by Betty Wang, CFP® and founder and president of BW Financial Planning.)

Remember to deduct any financial help your employer offers for child care prior to calculating your dependent care credit. Occasionally, an employer will provide a child care stipend, and that amount doesn’t count toward your tax credit.

The potential benefits of using the Child Care Tax Credit

The Child Care Tax Credit can be a great option for parents looking to reduce the impact that child care costs have on their monthly budgets. A few of the benefits of this tax credit are:

• The Child Care Tax Credit is a direct way to lower the amount of taxes you owe.
• If your family earns less than $125,000 a year, the tax credit may provide a larger benefit to you than it does for a family who earns more.
• The Child Care Tax Credit is an excellent way for individuals without a Dependent Care FSA option to offset some of the cost of child care for their family.

The potential disadvantages of the Child Care Tax Credit

Although saving money on your taxes may feel like it’s always a good idea, there are a few drawbacks to the Child Care Tax Credit to keep in mind.

• The limits on the Child Care Tax Credit are lower than what many families spend each year on child care.
• If you’re a high-income family that earns over $125,000, the tax benefits that come with using a Dependent Care FSA may save your family more money than the Child Care Tax Credit.

Can I use a Child Care Tax Credit and a Dependent Care FSA?

With both of these money-saving options available, you might be wondering if you can take advantage of them simultaneously to maximize your savings. Some stipulations restrict who can utilize both the Child Care Tax Credit and the Dependent Care FSA in their financial planning. And, in many cases, you may have to choose only one option for your family and childcare expenses.

However, there are some exceptions. For example: if your family has two or more kids and you’ve already maxed out your Dependent Care FSA to the $5,000 limit but your qualifying child care expenses hit or exceed the $6,000 cap for the Child Care Tax Credit — you can take advantage of both the FSA and the Tax Credit. The Child Care Tax Credit will only be applicable on the $1,000 that was “unreimbursable” from your FSA. So if your income puts you in the 20% credit range, that could save you another $200 on taxes.

Which option is right for your family?

If you’re in a situation where you need to pick between the Dependent Care FSA or the Child Care Tax Credit, you should start by calculating your total child care expenses each plan year, and the benefits you’d receive using each program.

You should also consider how you’d maximize tax savings with whatever vehicle you choose. A great way to do this is by staying aware of what expenses qualify for either the Dependent Care FSA or the Child Care Tax Credit. For instance, you may know that daycare or preschool qualifies as a deductible child care cost. But did you know that after-school care or day camp during the summer or school breaks may also qualify as eligible expenses for either option?

It’s also important to be clear on which babysitting options qualify as a deductible expense and to make sure you keep receipts, a contract, or pay your babysitter via a third-party wage system, so you have all your paperwork in place.

Think about your overall financial picture

Remember, as with any decision involving taxes, your budget, or your child care options, maximizing your total savings isn’t about picking the “best” option out there — it’s about picking the right option for you and your family. Keep in mind that, while it’s tempting to save money on taxes by using either tax credits or tax-friendly accounts, you should also make sure that your tax savings plan fits into your big-picture financial goals. Speaking to a tax professional can help you to decide whether the Child and Dependent Care Tax Credit or the Dependent Care FSA (or both) is a better option for you — and speaking with a comprehensive financial planner can help you structure a plan that addresses your child care costs and balances them with your other expenses and savings goals for your family.