Summer Childcare Budgeting – FSA or Tax Credit?
We’ll be the first to admit, summer is great! Fun, vacation, relaxation, and adventure are in full force during this season. Kids’ enthusiasm is just as warm as the air, with schools likely to remain closed for several more weeks. As exciting as it is for parents to experience this enjoyable season, there are almost always financial questions about budgeting during the summer. There’s simply no way around the fact that childcare is expensive. However, not every household is taking advantage of two available strategies to help cover the cost of the pricey summer season: using a Dependent Care Flexible Spending Account (FSA) and taking the Child Care or Dependent Care Tax Credit. Let’s explore each option.
Dependent Care FSA
A Dependent Care FSA is an employer-sponsored account that deducts qualifying childcare expenses from each employee’s paycheck using pre-tax dollars. Examples of qualifying childcare expenses include preschool, nursery school, day care, before and after school care, and summer day camp. Eligible dependents include children under the age of 13 or those who are physically unable to care for themselves. For 2023, the maximum annual contribution to a Dependent Care FSA is $5,000 per household or $2,500 if married and filing separately. Each FSA also requires a minimum annual election of $100. One major perk of having a Dependent Care FSA is that it is funded with pre-tax dollars, which helps reduce your total taxable income. These funds are also exempt from the 7.65% Social Security and Medicare tax, and often from state taxes as well. For example, someone in the 24% tax bracket who contributes the maximum $5,000 per year would save about $1,200 annually in federal income tax. A drawback of the Dependent Care FSA is that it is a “use-it-or-lose-it” account. Participants cannot roll over their funds to the following year. Tracking receipts and qualifying costs can be tedious, and it’s essential to make sure that all expenses are eligible for reimbursement.
Child Care Tax Credit
To qualify for the Child Care and Dependent Care Tax Credit, one must have work-related expenses for childcare. Essentially, both parents must work, and the government requires both parents to provide proof of income, with exceptions for disabled spouses and/or full-time students. The care must be for qualifying children under the age of 13. Additionally, if a spouse or dependent lives with the taxpayer for more than half the year and is physically or mentally incapable of taking care of themselves, they also qualify. The credit’s value is limited, with up to 50% of qualifying childcare costs covered for households earning $125,000 or less. As household income increases, the percentage of eligible credit decreases. The Child Tax Credit is worth up to $2,000 per qualifying dependent under the age of 17 who lives with you for more than half the year, provides no more than half of their own financial support throughout the year, and is a U.S. citizen, U.S. National, or U.S. resident alien. Using the Child Care Tax Credit is a simple way to lower the amount of taxable income for a household. It is also an option for households without a Dependent Care FSA to offset some childcare costs, but the limits on the Child Care Tax Credit are usually lower than what families spend annually on childcare. For high-income families earning over $125,000 annually, the tax benefits from a Dependent Care FSA will likely save more than the Child Care Tax Credit.
The Child Care Tax Credit and Dependent Care FSA sound great … can my family do both?
Probably not. Often, a household has to choose only one option for family and childcare expenses. However, some conditions allow a family to use both. For instance, if you have two or more children and your Dependent Care FSA has reached the $5,000 limit but your qualifying childcare expenses have exceeded the $6,000 cap for the Child Care Tax Credit, you can take advantage of both the FSA and Child Care Tax Credit. In this case, the $1,000 that was not reimbursed from your FSA could save you an additional $240 on taxes if your household is in the 24% tax bracket.
If you’re forced to choose between a Dependent Care FSA or the Child Care Tax Credit, the best thing to do is start tracking expenses that qualify for either option. It’s easy to ask any daycare or summer school if their expenses qualify for either. If you use a babysitter or nanny service, it’s important that their wages are tracked with a third-party system and routinely checked.
A tax professional can help you decide whether the Child and Dependent Care Tax Credit or the Dependent Care FSA is a better option. Furthermore, having a comprehensive financial plan that addresses childcare costs along with budgeting and savings goals can help you feel even more confident about your entire financial future. Feel free to reach out to Team Savant with any financial questions, and enjoy the rest of your summer!
This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant. The scope of the services to be provided depends upon the needs of the client and the terms of the engagement.