There are two different ways to calculate daycare expenses on your tax return, and which method you choose could be costing you.
There are many issues for individuals to consider when preparing their tax returns. Given the extremely high cost of child daycare, taxpayers should determine what is the most proficient method tax-wise to pay for this care. Let’s look at the two tax methods of paying for child daycare.
Method 1: Child & Dependent Care Tax Credit
With method 1, the Child and Dependent Care Tax Credit (taken with form 2441), you would claim daycare expenses on your tax return and receive a credit back (see below). This is for qualifying child care you paid for a qualifying person that you can take a child tax credit for and payments you make to a facility/organization that provides child care.
Note: The child care provider does not need to be licensed, as long as you can show the name and tax identifier number of the person you paid (e.g. an aunt, a family friend, etc.) A “Qualifying Person” is a child under the age of 13 whom you claim as a dependent, disabled spouse who is not physically or mentally capable of taking care of themselves (and other situation for disabled individuals). Divorced or separated taxpayers have special rules that apply—see the Separation or Divorce decree or call us at (978) 774-7700 for more information.
Let’s look at the tax ramifications for method 1 (The Child and Dependent Care Tax Credit, form 2441): Allowable child care expense is capped at $3,000 for one qualifying person and $6,000 for two or more. This is then multiplied a number ranging from 35% to 20% based on your Adjusted Gross Income. For example, if you have two children and $6,0000 of qualifying daycare costs, and the highest income tax bracket, the calculation for the Child & Dependent Care Tax Credit would be as follows: 20% x $6,000 = $1,200.
Method 2: Pre-Tax FSA Plan
We can now look at method 2: the qualified pre-tax dependent care flexible spending account with your employer. This is an employer-sponsored plan (pursuant to IRC 125 Cafeteria Plan) that allows an employee to exclude a maximum of $5,000 per year on qualified child care costs from wages. The tax savings in this situation would be $5,000 multiplied by your Marginal Tax Bracket. The calculation is as follows, assuming a 25% marginal tax bracket: $5,000 x 25% = $1,250.
Note: If you have an FSP, you will still need to report your expenses on day care on the Child Tax Credit Form.
Method 1 vs. Method 2: Some Examples
Now, let’s compare the two methods of paying for child care using the following situations:
1. One child with daycare cost of $3,000, taxpayer has $25,000 adjusted gross and in the 15% marginal tax bracket. The comparison is as follows:
Form 2441 - $3,000 X 30% = $900 child tax credit
Employer FSA Plan - $3,000 X 25% = $750 tax savings
In this situation the most beneficial tax savings is utilizing Form 2441 for child tax credit.
2. Two children with daycare cost of $6,000, taxpayer has $45,000 adjusted gross and in the 15% marginal tax bracket. The comparison is as follows:
Form 2441 - $6,000 X 20% = $1,200 child tax credit
Employer FSA Plan - $5,000 X 15% = $750 tax savings
In this situation the most beneficial tax savings is utilizing Form 2441 for child tax credit.
3. Two children with daycare cost of $6,000, taxpayer has $145,000 adjusted gross and in the 25% marginal tax bracket. The comparison is as follows:
Form 2441 - $6,000 X 20% = $1,200 child tax credit
Employer FSA Plan - $5,000 X 25% = $1,250 tax savings
In this situation the most beneficial tax savings is utilizing Employer FSA Plan child tax deduction.
4. Three children with daycare cost of $12,000, taxpayer has $160,000 adjusted gross and in the 30% marginal tax bracket. The comparison is as follows:
Form 2441 - $6,000 X 20% = $1,200 child tax credit
Employer FSA Plan - $5,000 X 30% = $1,500 tax savings
In this situation the most beneficial tax savings is utilizing Employer FSA Plan child tax deduction.
As you can see from the above calculations, it is important to project your tax situation for the upcoming year to determine the best method of paying your child daycare costs. At Terranova & Associates, we have the expertise to help you plan for a future that saves you the most on child care. Call us at (978) 774-7700 to schedule a consultation.
Written by: Thomas D. Terranova, Jr., CPA, PFS, CITP
Edited by: Alison Pappavaselio