Dependent Care Tax Benefits: Tax Credits & Employer Plans
Dependent care tax benefits are specifically related to the costs of caring for a person who qualifies as your dependent so you can go to work. Your dependent may or may not be your child.
Note that the child and dependent care credit is completely separate from the Child Tax Credit. The child tax credit is available to parents/guardians of minor children, whereas the child and dependent care credit specifically relates to care expenses so a person can work.
Child and dependent care credit
The child and dependent care credit is a personal tax credit. This credit is for expenses paid for care of a qualifying person to enable a taxpayer or taxpayers spouse to work. This tax credit has many rules and caveats. This blog is an overview and the credit is further explained in IRS Topic 602: Child and Dependent Care Credit and other IRS links provided below. Discuss with your tax professional to see if you qualify for this credit.
Amount of the credit
The maximum expenses you can use for this deduction in 2022 are $3,000 for one qualifying person or $6,000 for two qualifying people. The credit is only a portion of the expense. The maximum credit for one child/dependent is $1,050 and for two children/dependents is $2,100.
If you get a dependent care benefit from your employer, you have to deduct those amounts from the qualifying expenses before figuring your personal tax credit.
Higher income earners receive a reduced credit or may not be eligible for a credit. For 2022, the amount of the credit begins to be reduced when adjusted gross income exceeds $15,000 and when adjusted gross income reaches $438,000, the credit is zero.
Qualifying person
You may deduct expenses for a qualifying person defined as:
- Your child under age 13 at the time care was provided
- Your spouse or dependent person who was unable to care for themselves who lived with you more than half the year
There are several rules and limitations for determining who is a qualifying person. See IRS Publication 503 page 3-4, under the heading Who Is a Qualifying Person?
Earned income
You must have earned income to take this credit. Earned income includes income you earned from a W2 job, business net profit earned from self-employment, other taxable income plus non-taxable combat pay. Exceptions exist for spouses who are full time students and spouses who are unable to care for themselves. See IRS Publication 503, page 4-6, under the heading You Must Have Earned Income for full rules.
Work-related expenses
The dependent care expenses need to have been incurred so that you could work or to look for work. If you are married, generally both you and your spouse need to be working or looking for work. There are exceptions for taxpayers who are full time students or could not care for themselves. There are many rules around expenses you can include. See Publication IRS 503, page 6-9, under the heading Are These Work-Related Expenses?
Note: To qualify for this credit a family member can care for your dependent as long as they are not your spouse, a parent of a child dependent, another dependent, your child under age 19, or another child for which you qualify to take this credit. See the fourth FAQ on this page for limitations on family members providing the care: Child and Dependent Care Credit & Flexible Benefit Plans
Not for married filing separate status
You may qualify to take this credit if you file your taxes with the status of single, head of household or married filing jointly. You cannot qualify to take this credit if you file married filing separately. However, certain taxpayers can be legally married, live separately from their spouse and file other than married filing single if they meet certain qualifications. See IRS Publication 503, page 9, under the heading What's Your Filing Status?
Taking the deduction
To take the deduction you have to provide the name, address and social security number or other tax ID from the person/entity providing the care. You can use IRS Form W-10 to document this information. See the third FAQ on this page if you cannot obtain your care providers social security number: Child and Dependent Care Credit & Flexible Benefit Plans
Note: if you pay a someone to provide care in your home, you may be required to pay payroll tax and withhold tax from their pay. See this IRS page regarding Hiring Household Employees.
Included costs
When calculating costs to compute the credit, the deduction will include
- Expenses paid during the calendar year for that years care.
- Expenses that were prepaid in a prior year for this year.
You cannot include cost you prepaid for a future year. For example. If in 2022, you advanced paid $500 for 2023, then that amount is not counted for 2022. It would count in 2023.
The following costs are not included in the calculation for the credit.
- Amounts you received as reimbursement from an employer.
- Amounts an employer paid to a care facility directly on your behalf.
- Value of care your employer provides at no cost to you, such as at an on-site daycare facility.
- Any pretax contributions made under a dependent care flexible spending arrangement provided by an employer.
- Educational costs: kindergarten is considered an educational cost, however, before and after school care is considered a dependent care cost. See the first FAQ on this page: Child and Dependent Care Credit & Flexible Benefit Plans
Essentially, if you received some help with dependent care costs through an employer, or any tax benefit through another option like a dependent care FSA, your personal tax deduction will be reduced.
Employer dependent care plans
A business can establish a dependent care assistance program for employees who need daycare or other care assistance for dependents to be able to work. The non-taxable amount of these contributions are reported in box 10 of the employees Form W2.
The employer dependent care assistance program can be established in one of three ways:
- A dependent care flexible spending arrangement
- An on-site daycare facility
- Reimbursements to employees
If highly compensated employees are included in the dependent care assistance plan, there are tests to ensure the plan does not discriminate in favor of the highly compensated employees. If the plan does discriminate in favor of highly compensated employees, the highly compensated employees cannot have their benefits excluded from their wages. This rule ensures that the plan primarily benefits workers who are paid average or lower amounts.
Flexible spending arrangement
Dependent Care Flexible Spending Account (DC-FSA) and is a type of cafeteria plan. Self-employed owners and more than 2% owners of an S-Corp cannot participate in cafeteria plans. However, these owners may be able to get other benefits and may take the personal dependent care tax credit. See more about owners below.
Under a DC-FSA, employees can elect to have funds withheld from their pay and contribute to the dependent care account, up to $5,000 ($2,500 for those married filing separately) to pay dependent care costs. The funds are non-taxable but need to be spent timely. Amounts that are not used during the plan year are typically forfeited.
Having a DC-FSA requires a written plan. Employers can elect to contribute a portion of the funds to the DC-FSA if they wish, but the maximum total contribution remains the same whether all the contributions are from the employee or part is from the employer.
Note: Due to the pandemic, employers in 2021 could have elected to increase DC-FSA amounts to $10,500 ($5,250 or married filing separately). This is to enable taxpayers to use amounts they could not use in 2020 when their care providers were shut down. See additional rules here: IRS Publication 503. Further, unused funds are typically forfeited at the end of the year, however, due to the pandemic the IRS modified these rules. See IRS Notice 2021-15 and 2021-26 for more information.
On site daycare and employer reimbursements
If an employer provides an on-site care facility, the fair market value of the benefit is calculated and included in Box 10 of the employees W2, which is then used to compute the tax savings on the employees personal return. If the fair market value exceeds the maximum benefit, the excess amount is considered taxable to the employee. For example, if the fair market value of the on-site daycare is $6,000 for the year, the most that can be excluded from wages is $5,000 so the remaining $1,000 will be taxable to the employee as a taxable benefit.
If the employer directly reimburses an employee for expenses, this is the amount up to $5,000 ($2,500 for an employee that files married filing separate) that will go in Box 10 of the employees W2. Excess amounts are taxable to the employee.
Credit vs. income exclusion
A tax credit reduces your total tax. For example, if after adding up all your income and calculating your tax, you owe $800 in tax, a $500 tax credit would mean you now only owe $300. The credit reduces the actual dollar amount of tax you owe.
The child and dependent care credit discussed above is a credit that is equal to 35% of your dependent care costs. If you have $6,000 in dependent care costs for two dependents, your maximum credit is $2,100, which can be further reduced the higher your income.
Employer provided dependent care assistance is not a tax credit. These programs exclude amounts from your taxable income. This means that if you earned $50,000 and receive an income exclusion of $5,000 from an employer benefit (making $5,000 of your income not taxable) then only $45,000 of your income will be subject to tax. With an income exclusion, you cannot easily determine how much tax this will save you. The tax has to be calculated to determine the savings.
Whether a credit or an income exclusion results in a lower tax amount will depend on several factors. A tax professional can help determine which is preferable in your case.
Form 2441
The IRS uses Form 2441 to determine your tax benefits for dependent care expenses. This form is filled out by your tax professional or tax software. It has three parts:
- Information about persons who provided the care.
- Calculation of the child dependent care credit, which is a personal tax credit.
- Calculation of dependent care benefits provided from an employer to determine if these amounts can be excluded from income and how much they will reduce the personal dependent care credit.
Business owners
Business owners can take advantage of the personal dependent care credit if they qualify. However, participating in an employer provided plan they have established for their employees is more complicated.
Self-employed
Self-employed owners such as sole proprietors and single member LLC owners do not have W2 wages, and as a result, any benefit for the owner under an established benefit plan can be deducted on Schedule C, Schedule E or Schedule F. You would use Form 2441 to determine how much is eligible for deduction. The instructions for Form 2441 Line 24 explain: https://www.irs.gov/instructions/i2441. Tax professional can help you determine if you taking the personal dependent care credit or the business deduction will provide the better tax outcome.
S-Corp owners
More than 2% S-Corp owners can establish a dependent care plan and participate, but the owners benefits are not eligible to be excluded from wages. The S-Corp owner would still be eligible for the personal dependent care tax credit.
Bottom line
The IRS provides several ways to reduce income tax due to having work-related dependent care costs. Which tax benefit is available to you and which is preferable if you can take advantage of more than one option, depends on many factors. if you have dependent care costs, discuss your options with a tax professional.
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