Children are expensive. With so many costs for health insurance, doctor appointments, clothing, food, activities, toys, and more, by the time you are ready to get back to work, the childcare costs can blindside you.
But, did you know that you can deduct the cost of childcare to save on your taxes? Through the Childcare Tax credit or by utilizing your employer-sponsored Flexible Spending Account, you could save big on taxes.
These programs won’t completely offset the cost of daycare, but, hey, every dollar counts.
Dependent Care Flex Spend Account
The National Association of Child Care Resource & Referral Agencies reports that most families pay somewhere between $3,582 to $18,773 a year on child care, but families in the most expensive cities can pay upwards of $2,000 per month.
The government recognized that this high cost can interfere with your ability to earn income and hold a steady job, so the IRS implemented the flexible spending account in the 1970s.
Flexible Spending Accounts (FSA) are a type of pre-tax account you can open through your employer. A Dependent Care FSA allows you to set aside a portion of your paycheck for eligible childcare expenses. Like your 401(k) or IRA, every dollar you contribute to this account uses pre-tax dollars, meaning you do not pay income taxes on your contributions.
If you contribute $5,000 per year, the current maximum contribution, to pay for childcare costs and fall into the 28% tax bracket, you would save $1,400 per year by participating in your employer’s FSA. That is some serious cash savings. The highest earners in the 39.6% bracket could potentially save $1,980 per year.
Unlike with a healthcare FSA, both spouses cannot contribute to the maximum at their respective employers. The limit is still $5,000. Even if you both have access to an FSA with a $5,000, if you go over the $5,000 limit you will be taxed on dependent care FSA contributions above $5,000 per household.
How You Use It
In most cases, you set up your Dependent Care FSA during open enrollment at the end of each calendar year for the next calendar year. When doing so, you can choose your payroll deduction amount and how much you want to contribute for the year.
Unlike a healthcare FSA (which most people are familiar with), you don’t get access to your pre-planned dependent care contribution immediately. With this type of FSA, you can only access the funds as you contribute to the account.
Additionally, you cannot use Dependent Care FSA funds for healthcare expenses or Health FSA funds for dependent care expenses. You can use one FSA for multiple children, but the funds are not fluid between healthcare and childcare related flexible spending accounts.
The big downside of FSAs is that they do not provide the option for a rollover at the end of the year. In other words, if you don’t use it, you lose it.
This is why it is important to be as accurate as possible in estimating costs before choosing your next year’s contribution. It is best for most people to add up all expected costs for the year but not pad it with too much extra. Additionally, be sure to keep your receipts and invoices for qualified tax credits in case of an audit or dispute.
Dependent Care FSA Pros:
- Easy enrollment and administration through your employer
- Pay expenses with a dedicated FSA debit card
- Lower income reported on your annual W-2 for lower taxes
- Up to $5,000 deduction per household
Dependent Care FSA Cons:
- If you don’t use it, you lose it
- Not available from all employers
- More administrative work to track receipts and reimbursements
The Childcare Tax Credit
If you work for a small employer that does not offer an FSA or are self-employed, you are not out of luck. You can use the Childcare Tax Credit for a similar tax saving. However, unlike the FSA, your savings are a bit more complicated to calculate.
The Childcare tax credit works differently than a deduction. It directly lowers your taxes due, which is generally more valuable than a deduction. In this case, the deduction is based on your income and your dependent care expenses.
To figure out how much your credit is worth, follow these steps:
- Start by adding up any direct expense you have related to dependent care. If in doubt on what qualifies, review IRS publication 503 for a full listing. The current maximum is $3,000 for one dependent or $6,000 for two or more dependents. If your spending is at or above the limit, you should calculate your savings based on the full limit.
- Once you’ve added everything up, subtract any financial assistance you received from your employer to help pay child or dependent care expenses. Some employers offer a stipend for dependent care, and that stipend amount is not tax deductible.
- Next, look up your percentage you can claim as a credit. This starts at 35% for the lowest income earners and goes down to 20% for anyone earning $43,000 or more. Use your adjusted gross income on your 1040 tax form, not your total income. You can find your exact percentage and more details for this calculation in IRS publication 503.
The maximum potential savings for someone with multiple dependents and the 35% credit bracket is $2,100 per year. Depending on your income and childcare expenses, your specific credit is likely lower than that amount. The maximum savings for a family who earns over $43,000 per year is $1,200.
Childcare Tax Credit Pros:
- Tax credit that directly lowers your tax bill
- Less administrative work throughout the year
- Easier option for self-employed individuals or those without an FSA at work
- Bigger benefit for families earning less than $43,000 per year
Childcare Tax Credit Cons:
- More complex calculation for your taxes
- Lower benefit for higher-income families
Which Makes Sense for You?
You can’t use both an FSA and the Childcare Tax Credit to save on the same dependent care expenses, so it is important to choose the method that will save you the most money on your taxes while taking the least amount of work.
If you have multiple dependents, there is a potential to use an FSA for one child and take the childcare tax credit for the other. To better understand making the right decision, let’s use an example.
Family with One Child
- Family with $120,000 total household income
- 1 dependent child
- $900 monthly child care expense
- 2 working parents with access to an FSA
Starting with the FSA, this family should take advantage of the maximum $5,000 to help pay the annual $10,800 childcare cost. Assuming biweekly payroll, this would require a $192 deduction every payday. This family has a top Federal tax bracket of 25%, so the FSA contribution would save $1,250 come tax season.
If this family opts for the Childcare Tax Credit instead, the tax saving calculation does not take place until the end of the year. Even if this family forgot about their FSA during open enrollment, it isn’t too late for the Dependent Tax Credit until after taxes are filed. In this case, the family’s calculation would be based on the maximum $3,000 and use a 20% credit bracket. The total credit at tax time would be $600.
In this family’s case, they are better off with an FSA at a $650 difference.
Family with Two Children
- Family with $60,000 annual income
- 2 dependent children
- $1,200 monthly child care expense
- 1 working parent with access to an FSA
Now let’s take a look at a second family with the same income but two children. Thanks to discounts for multiple children, let’s assume this family spends $1,200 per month on daycare. Again, this family could take full advantage of their FSA at the $5,000 limit. Despite having two children, the savings are identical. By taking advantage of the entire $5,000 FSA limit, they would save $750 on their taxes.
With multiple children, the Childcare Tax Credit works differently. Instead of basing their tax credit calculation on the $3,000 limit, they would use the $6,000 limit for families with two or more children.
Based on the 20% credit bracket, the family would save $6,000 x 20%, or $1,200 on their taxes. In this case, the Childcare Tax Credit is definitely the best method for saving on tax day.
Picking the Best Way to Save on Childcare
Are you self-employed? If so, you can take advantage of the tax credit but not the flexible spending account.
Do you have multiple children? That might make the tax credit favorable to the FSA. Every family is different and every family’s finances are different. The only way to know which option is the best for you is to whip out your trusted calculator and do the math.
The worst thing you can do is ignore this completely. You should work to save every dollar you can on your taxes, and dependent care is a common credit for families with children. If you are sending your kid off to daycare, you might as well save a few bucks along the way.
Eric Rosenberg is a finance, travel, and technology writer originally from Denver, Colorado living in Ventura, California. When away from the keyboard, he enjoys exploring the world, flying small airplanes, discovering new craft beers, and spending time with his wife and baby girl. You can connect with him at his own finance blog Personal Profitability.
While we hope this information is useful, it’s only intended to provide general education. It’s not legal, tax, or investment advice, and may not apply or be useful to your specific financial situation. Haven Life does not recommend, and cannot guarantee any products or services noted above.