If you have kids in daycare, you know what a financial burden it can be. The average cost for child care nationwide is over $12,000 annually per child and has risen dramatically during the COVID pandemic. Studies reveal child care expenses can represent between 10% and 18% of average family income.
Both Flexible Spending Accounts (FSAs) and the Child and Dependent Care Tax Credit have always offered some relief. Taxpayers determine what combination of the two options is the most beneficial for their situation. The recently enacted American Rescue Plan Act (ARPA) significantly increased the benefits for both FSAs and the Child and Dependent Care Credit, but the edge clearly goes to the tax credit for most. So much in fact that taxpayers who benefited more from maximizing FSAs in the past might find that is no longer the case. At least for this year. Unfortunately, the new rules just apply to 2021 so it will pay to be informed and nimble with any adjustments you make.
Flexible Spending Account Basics
FSAs for dependent care were created decades ago and have been widely adopted by employers. A Dependent Care FSA allows an employee (married filing jointly) to defer up to $5,000 pre-tax from their paycheck each year. The money can be used to pay out of pocket care expenses for children under 13, including the cost of daycare, preschool, nursery school, after school care, and summer day camps. The only catch is that it must all be spent within the year or you risk forfeiture. Use it or lose it.
Changes for 2021
Under the ARPA for 2021, the FSA pre-tax contribution limit has more than doubled to $10,500 for married filing jointly employees. That's big. Also, FSA plans now have the option to rollover any unspent balances from 2020 to 2021 (and from 2021 to 2022) which will also come as welcome news to many who were left with balances in their accounts due to COVID related closures.
Pre-Tax Savings Examples
Example: You and your spouse have an adjusted gross income (AGI) of $50,000 which puts you in the middle of the 12% federal tax bracket. You live in a high tax state which has an income tax of say 5%. FICA is 7.65%. Add those all up and you get 24.65%. The new maximum FSA contribution of $10,500 saves you $2,588 in taxes.
Example: Same facts except your AGI is $130,000 which put you in the 22% marginal tax bracket. The new maximum FSA contribution of $10,500 saves you $3,638 in taxes.
Child and Dependent Care Credit Basics
The Child and Dependent Care Tax Credit has also been key for working families over the years. The rules are a more complicated, but the main thing to remember is that it's a tax credit. That means a 1:1 dollar for dollar reduction of your tax bill versus a pre-tax dollar deferral like an FSA.
Under the pre-ARPA rules, a taxpayer is allowed a tax credit of between between 20% and 35% of qualifying child care expenses. The percentage is reduced (phased out) as your AGI goes up, but it doesn't go lower than 20%. There is a limit of $3,000 (for 1 child) and $6,000 (for 2 or more children) on qualifying child care expenses. Putting it all together, the maximum tax credit you can take under the old rules is $2,100 (35% of $6,000).
Changes for 2021
The ARPA changed the allowed credit percentage range to 0%-50%. Again, the credit percentage phases out as your AGI increases, but this time it can go all the way to 0% (ie no credit allowed). The limit on qualifying expenses was raised to $8,000 (1 child) and $16,000 (2 or more children). This means the maximum tax credit available for 2021 is $8,000 (50% of $16,000). A $2,100 credit in 2020 becomes an $8,000 credit in 2021!
One caveat is that you need have earnings to take the credit, and the credit can't be more than your earnings. For married couples, both spouses must have earnings and the credit can't be more than the earnings of the lowest earning spouse.
Tax Credit Examples
Example: You and your spouse have adjusted gross income of $50,000. You have 2 children and your 2021 childcare expenses total $16,000 (the maximum allowed expense). Your AGI qualifies you for the full 50% credit or $8,000.
Example: Same facts except you and your spouse have adjusted gross income of $130,000. Your AGI still qualifies you for a 47% credit or $7,520.
Tax Credit and FSA Together - Don't Double Dip
Double Dipping is when you receive a tax benefit twice for the same dollar. It's not allowed. In other words, you can't use pre-tax money from your FSA for childcare expenses and then claim the child care tax credit for those same expenses. You can and sometimes should utilize both an FSA and the Child and Dependent Care Tax Credit, but you have to keep the dollars separate and the combination cannot exceed the overall expense limits of $8,000/$16,000.
So Which Is Better?
The calculation essentially boils down to 1) your actual child care expenses and 2) whether your combined marginal tax rate percentage (federal, state, local, FICA/self-employment tax) exceeds your allowed percentage for the tax credit.
Pre-ARPA: Lower income families clearly benefit more from the tax credit. Higher income families tended to benefit more from the pre-tax FSA. Mid level income families went both ways. Many (with AGIs over $45,000) found themselves in the 20% tier for allowable tax credit. Depending on where they lived, their combined tax rate percentage could easily exceed that 20% thus making pre-tax FSAs the better choice. It's those middle income taxpayers who were utilizing dependent care FSAs who should definitely be taking a look at their scenarios this year.
ARPA for 2021: Lower income families will continue to benefit even more the by taking the tax credit. But for middle and even upper middle income families this year will be different. The revised tax credit is quite compelling if your AGI is around $125,000 or less and you can squeeze into the new 50% rate or close to it. You may well derive a greater benefit by reducing your FSA contribution this year, especially if you have just 1 child. Take the $4,000 tax credit on the entire first $8,000 in qualifying expenses.
For 2 or more children, the qualifying expense limit is $16,000. Again, if you have that level of expenses and your AGI is under $125,000, you are allowed an $8,000 tax credit (50% of $16,000) which is pretty hard to beat with FSA pre-tax savings. However, if your AGI exceeds $125,000, your allowable percentage is phased down into the lower ranges. See the table above. At 20% you might only be able to take a $3,200 credit on the same $16,000 in expenses. In that case you should consider the pre-tax benefit of maximizing your FSA. Contribute the maximum $10,500 pre-tax and take the tax credit for the remaining expenses under $16,000.
As always at Monadnock Tax Services we are happy to help individuals and families with friendly tax advice and services. Give us a call at (603) 722-0184 or email info@monadnocktax.com