Child Care and Dependent Care Tax Breaks
If you qualify, you have additional tax credits available. Basically, a child care tax credit allows you to deduct 20 to 35 percent (depending upon your adjusted gross income) of the first $3,000 you spend per dependent child, per year for qualified child care.
A dependent care account allows your employer to set aside a certain amount in pretax dollars to be spent on dependent care per year; this amount cannot be greater than your earned income for the year. You can use both credits to reduce your tax bill, but sometimes the greater benefit comes from selecting one over the other. (See Dependent Care Accounts later in this chapter for more information on how these tax breaks compare.)
The IRS outlines its requirements in Publication 503, “Child and Dependent Care Expenses.” Basically, the qualifications that must be met for both are as follows:
The child must be considered your dependent.
The child must be under the age of 13 or physically or mentally not able to care for herself.
The parent must work part-time or full-time outside of the home or be a full-time student.
The childcare provider must be a licensed day care provider, preschool provider, or legal nanny, and must not be someone you can claim as a dependent. The caretaker can be over 18 years old and a child of the taxpayer if not a dependent, however. Other rules apply if the father of the child is paid — IRS Publication 503 has more information.
The time spent must be used working, looking for work, or attending school full-time.
The payment must be for child care only — not for household chores.
Child Care Tax Breaks
The total amount of your child care credit cannot exceed your earned income for the year unless you have significant physical or mental limitations that impair your ability to work or study. If you have no income but are a full-time student, you may still be eligible for a child care tax break of $250 for one child or $500 if you have more than one child.
Before hiring a caretaker or placing your child in a day care center, make sure that you acquire the necessary information. Without proper documentation, your payments aren't likely to qualify for this tax break. If the child care provider is a tax-exempt church or school, you can still claim the tax break by writing “tax exempt” in the proper space on the tax form.
Preschool expenses qualify for the child care tax breaks, but once a child enters first grade, you cannot include educational expenses, such as a private school. Unless they are full-time students, stay-at-home mothers are not eligible for child care tax breaks.
Note that you will be required to provide the name, address, and Social Security number or employer or taxpayer ID of the child care provider, as well as the exact amount paid on the IRS Form W-10, “Dependent Care Provider's Identification and Certification.”
Dependent Care Accounts
If your income puts you in the 28 percent tax bracket and your employer offers the option, you may want to opt for a dependent care account in addition to, or in lieu of, the child care tax break. Note that these accounts must be established by an employer and are limited to your earned income.
They also involve planning and paperwork, but if you earn enough money, they can be well worth the effort. For instance, if you set aside $2,500 and are in the 25 percent tax bracket, you immediately save $625 in federal taxes. You also pay less in Medicare and Social Security taxes and may pay fewer state and local taxes.
If your employer offers a dependent care account, jump on board, but make sure you understand the following basics before establishing the account:
Your child care provider must meet the qualifications described in the preceding section.
You should fund the account based on the maximum you are allowed to deduct. The IRS determines the maximum amount that an employer can set aside. Though this amount changes from year to year, it can never exceed your earnings in any given year.
Budget carefully. Any funds not spent will revert to your employer at the end of the year.
Save your receipts and submit them to your employer promptly for reimbursement.
Review, make any adjustments, and, if it's working for you, make sure you re-enroll annually.
Dependent care account contributions are deducted from the permitted child care base of $3,000 per child. In some cases, it might make more sense to use only the child care tax break. For example, if you contributed $1,500 to a dependent care account, you would deduct that from your $3,000 base. That would leave you with $1,500, of which 20 percent, or $300, is deductible. If you eliminated the dependent care account, on the other hand, 20 percent of $3,000 leaves $600 deductible.