Guest Post By Matt Elliott, CFP®, CSLP® of Pulse Financial Planning
Changes to the 2021 tax code have made planning for your child and dependent care tax benefits even more crucial than in previous years. By coordinating your Dependent Care Flex Savings Account (DCFSA) and Child and Dependent Care Tax Credit (CDCTC), you could potentially shave thousands of dollars off your tax bill. Here is what you need to know about changes to these programs in 2021 (and beyond) to optimize your tax bill.
What Is a Dependent Care Flex Savings Account (DCFSA)?
Dependent Care Flex Savings Accounts are special accounts that allow you to set aside money for childcare before taxes are taken out. The account is only available through your employer. If your workplace does not offer a DCFSA, you are unable to take advantage of this benefit (you can skip this section and focus solely on the Child and Dependent Care Tax Credit). If you do have access to a DCFSA though, they come with huge potential tax benefits as well as some key decisions you will need to make to maximize those benefits.
DCFSA Account Benefits
- Offers tax savings when used for eligible child or dependent care expenses.
- Account offered through employer payroll reduction.
- Contribution limit is up from $5,000 to $10,500 for 2021 (but not all plans adopted the higher limit).
- Contribution elections are made during open enrollment.
- May be eligible to make changes mid-year in some cases.
- Unused funds are generally forfeited. Exceptions may be made in 2021, check with your plan provider to verify if they will allow a carryover.
If you have difficulty wrapping your head around these types of accounts, here is one way to think about it: if you let your paycheck flow through regular payroll, you are going to have federal, state, and FICA taxes taken out before the money hits your bank account. Of course, you can then use that after-tax money to buy anything you want. If you know you will be spending your money on childcare anyway, though, why not skip the taxes? With a Dependent Care FSA, you can divert up to $10,500 (2021) without having any taxes siphoned off the top.
DCFSA 2021 Contributions
Contributions to a DCFSA are made with pre-tax dollars through a salary reduction. Typically, these accounts are established through your employer during open enrollment, and you are stuck with your election for the entire year. Rules are more lenient in 2021, though, so contact your employer if you are interested in making a mid-year change to your plan.
The maximum contribution limit to a DCFSA account is $10,500/year ($5,250 if married filing separately) for 2021. However, not all plans adopted the new higher maximum contribution and are sticking with the old $5,000 limit. The contribution limit is scheduled to drop back down to $5,000 in 2022, but there is a fair chance that these new higher limits are made permanent.
Contributions to your DCFSA are exempt from federal, Social Security (FICA), and most state taxes. Depending on your income and state, your tax savings can easily exceed 40%. The higher your tax bracket and higher your state taxes, the more attractive a DCFSA is.
Do not elect to contribute more than what you reasonably expect your qualified childcare costs to be. If you have funds left in your account at the end of the year, they are typically forfeited. However, due to pandemic-related relief that was passed, you may be eligible to carryover any unused balance into 2022. Check with your plan provider before counting on a carryover as some providers may choose to set their own more stringent rules.
Common Dependent Care FSA eligible expenses include:
- Nanny expenses
- After-school or extended-day programs
- Dependent care center
- Au pair
- Expenses paid to relative for dependent care
- Preschool and nursery school
- Summer day camp (if primary purpose is custodial and not education)
These are examples and not intended to be a comprehensive list. Contact your DCFSA provider if you have specific questions about expense eligibility. Care providers may need to meet specific requirements for expenses to be eligible.
Before planning on using a DCFSA, verify:
- That your employer offers a Dependent Care FSA.
- That your employer will allow you to start or change contributions mid-year if you are not already taking advantage of one. If not, make sure to address this during next year’s open enrollment.
- That your specific dependent care expenses qualify to be reimbursed from the account.
Can Both Spouses Contribute to DCFSA?
If you are married, and both spouses have access to a Dependent Care FSA through your employer, which spouse should contribute? If you both earn less than the Social Security wage base ($142,800 in 2021), it really doesn’t matter. However, if one spouse earns more than this, and one earns less, the best strategy is to have the lower-earning spouse contribute to the DCFSA.
The reason is FICA tax is paid per earner (not based on joint income, like most taxes). The higher earner only pays about 2.35% FICA tax on wages above the Social Security wage base, and the lower earner is still paying the full 7.65% in FICA tax on their paycheck. This means that the lower earner stands to save about 5.3% more in taxes than the higher earner by using a Dependent Care FSA. On an annual $10,500 contribution, that could result in $556.50 in tax savings just by having the lower-earning spouse contribute to the account rather than the higher-earning spouse.
Dependent Care Flex Savings Account Case Examples
Sallie is a physician at the local hospital and earns $300,000 per year. Sam is a scientist and earns $75,000 per year. They are married and have 2 children—Sebastian is 4 and Sophia is 1. They live in Minnesota and are in the 32% federal and 9.85% state tax brackets.
Both Sam and Sallie’s employers offer a Dependent Care FSA. Sam and Sallie had $25,000 in eligible childcare expenses last year and expect it to be about the same in 2021. Since Sam is the lower-earning spouse, he elected to contribute the maximum allowed $10,500 for 2021. By paying for childcare through their DCFSA, they can avoid 32% of federal, 9.85% of state, and 7.65% of FICA tax (a total of 49.5%) on $10,500 in eligible expenses. The result is a tax savings of $5,197.50 in 2021 for Sam and Sallie ($10,500 x .495 = $5,197.50).
John is a resident at the local hospital and earns $60,000 per year. Jane is currently in medical school and has no income. They are married and have a 2-year-old child. They live in Minnesota and are in the 12% federal and 5.35% state tax brackets. John’s employer offers a Dependent Care FSA to residents. John and Jane expect about $10,000 in qualified childcare expenses in 2021.
John works with Sam, and heard Sam touting how much money his family saves by utilizing their DCFSA. As a result, John thought he would take advantage of this, as well, and elected to contribute $10,000 for 2021.
By paying for childcare through their DCFSA, John and Jane can avoid 12% of federal, 5.35% of state, and 7.65% of FICA tax (a total of 25%) on $10,000 in expenses. The result is a potential tax savings of $2,500.00 in 2021 ($10,000 x .25 = $2,500.00). To see if this is the best strategy for the family, this number needs to be compared to the tax savings the Child and Dependent Care Tax Credit offers.
Child and Dependent Care Tax Credit (CDCTC)
- The amount of eligible dependent care expenses has increased in 2021 to $8,000 for one child or $16,000 for two or more children.
- The amount of your tax credit is determined by multiplying your eligible dependent care expenses by your Applicable Percentage.
- Your Applicable Percentage can be anywhere from 0%-50% depending on your Adjusted Gross Income (AGI) (regardless of your filing status).
- Those with an AGI less than $185,000 in 2021 will have an increased potential tax credit available compared to previous years.
- Those with an AGI more than $440,000 in 2021 will not be eligible for the CDCTC, even though they were eligible in past years.
- You cannot claim the Child and Dependent Care Tax Credit for expenses that were covered by your DCFSA. Expenses paid by the DCFSA still count toward your $8,000/$16,000 maximum amount of CDCTC eligible expenses.
Prior to 2021, the Child and Dependent Care Tax Credit was available to help offset some dependent care expenses of up to $3,000 for one child, and $6,000 of expenses for two or more children. This has significantly increased for 2021, allowing for up to $8,000 of expenses for one child, and $16,000 of expenses for two or more children.
Previously, the maximum percentage of eligible expenses (“Applicable Percentage”) you would receive a tax credit for was 35%, although the number ended up actually being 20% for most people (if your AGI was above $45,000, your Applicable Percentage was 20%). This resulted in a modest tax credit for those not taking advantage of a DCFSA. Due to higher potential benefits under both programs in 2021, it is worth revisiting how this tax credit will affect you in 2021.
The maximum Applicable Percentage for 2021 has increased to 50% and has a much higher AGI limit of $125,000 (regardless of your filing status) before your Applicable Percentage gets reduced. The Applicable Percentage phases out 1% for each $2,000 above the $125,000 limit until reaching 20%. So once your AGI is above $185,000, your Applicable Percentage will be 20%. A new phaseout begins again at $400,000, before the tax credit is completely phased out once AGI is above $440,000.
This one can be confusing, so here are some examples:
Your CDCTC will likely be significantly different than in previous years.
Most people with a qualifying dependent can expect a larger tax credit for 2021. The exception is for those with an AGI above $400,000. The phaseout of the credit now resumes at an AGI of $400,000 and is completely gone at an AGI of $440,000 (this was not a provision prior to 2021).
If your AGI was above $440,000, you were eligible for a credit in past years, but no longer in 2021. If the amount of taxes you will owe is different than it has been in the past, you may want to consider adjusting your tax withholding. The IRS has a handy calculator you can use here.
For now, the changes to the CDCTC are temporary provisions for 2021 only. However, many are speculating that at least some, if not all, of the changes may be made permanent.
Child and Dependent Care Tax Credit Case Examples
Sam and Sallie have an AGI of $349,900 in 2021. They had $25,000 in eligible childcare expenses. Sam and Sallie’s Applicable Percentage is 20%.
Their maximum amount of eligible expenses for 2 kids is $16,000 under CDCTC. Remember they already paid for $10,500 of childcare through their DCFSA. This means that only the remaining $5,500 of childcare expenses can be used to qualify for the CDCTC ($16,000 2 child max – $10,500 paid through DCFSA = $5,500). As a result, Sallie and Sam qualify for $1,100 in the Child and Dependent Care Tax Credit ($5,500 x .20).
John and Jane have an AGI of $34,900 in 2021. They had $10,000 in eligible childcare expenses. Sam and Sallie’s Applicable Percentage is 50%.
Their maximum amount of eligible expenses for 1 child is $8,000. As a result, John and Jane would qualify for $4,000 in the Child and Dependent Care Tax Credit ($8,000 x .50 = $4,000). To see if they can claim this credit, we need to examine how their DCFSA contributions affect the potential CDCTC.
Combining Dependent Care Flex Savings Account (DCFSA) and Child and Dependent Care Tax Credit (CDCTC)
Since you cannot claim the CDCTC for expenses reimbursed from your DCFSA, you need to decide which program to prioritize taking advantage of.
You can do this by calculating your Applicable Percentage (explained in the CDCTC section above) and compare it to your estimated total incremental tax burden (described in the DCFSA section above). Whichever calculation ends up with the higher percentage, is the program you should take full advantage of first in most cases.
If the CDCTC is more favorable for you, and you contribute to a DCFSA, you will be forfeiting the higher benefit that you would receive through the CDCTC. This is why planning ahead for which benefit will be more optimal for you is crucial.
The higher your income, the more attractive the DCFSA is, with lower incomes being better off with the CDCTC. This is because lower incomes will qualify for a higher Applicable Percentage in the CDCTC, while higher incomes will be able to avoid a higher tax burden with the DCFSA. In general:
- If your AGI is less than $125,000, the CDCTC is likely going to be the better option.
- If your AGI is more than $185,000, the DCFSA is likely going to be the better option. You may still be able take advantage of some of the CDCTC still depending on your income, amount of your contribution, number of kids, and amount of eligible expenses.
- If your AGI is between $125,000-$185,000, you need to run the numbers to decide which program provides you the most benefit.
- If you have 2 or more children, and max out your DCFSA, you may still claim some of the CDCTC if your eligible expenses were more than $10,500.
- If you have 1 child and eligible childcare expenses of more than $8,000, you need to run the numbers to see which program provides you the higher benefit. Since the DCFSA limit is higher ($10,500 vs $8,000), it may still come out better even if the Applicable Rate is slightly higher than the tax savings that the DCFSA would provide.
Combining DCFSA and CDCTC Case Examples
As discussed above, Sam and Sallie have 2 children and their Applicable Percentage is 20%, while Sam’s total incremental tax is 49.5%. Since the tax rate is higher than the Applicable Percentage, Sam should first max out his contribution ($10,500) to the Dependent Care FSA. Sam and Sallie can still take advantage of the Dependent Care Tax Credit on $5,500 of their remaining eligible expenses.
DCFSA Tax Savings: $5,197.50
CDCTC Tax Savings: $1,100
Sam and Sallie’s total tax savings is $6,297.50 by optimizing benefits from both programs.
As discussed above, John and Jane have 1 child and their Applicable Percentage is 50%, while their total tax savings is from a DCFSA is 25%. Since the Applicable Percentage is higher than the tax savings, they should take advantage of the CDCTC. However, they already elected to contribute $10,000 to the DCFSA, which will exclude them from using the CDCTC since they contributed more than the 1 child limit ($8,000).
So instead of a $4,000 tax credit through utilizing the CDCTC, John and Jane are unable to use the CDCTC at all. They instead saved $2,500 in taxes through the DCFSA.
Actual DCFSA Tax Savings: $2,500
Missed CDCTC Tax Savings: $4,000
By using the DCFSA instead of the CDCTC, John and Jane paid $1,500 in extra taxes in 2021.
During open enrollment for 2022, John and Jane will carefully project their income as well as childcare expenses before making the decision of using a DCFSA again next year. In the meantime, they can contact their DCFSA plan administrator to see if it is possible to make changes to their elections mid-year.
This is not intended to be individual tax advice. Hypothetical examples are simplified for illustrative purposes. The information provided is based on recent changes that could play out differently when the new rules are interpreted or if further changes are made. Consult with a tax professional for tax advice specific to your situation.