As the cost of daycare continues to increase, did you know that there is an IRS credit that may be able to offset some of the expense? It’s called the Child and Dependent Care Credit.
Who is eligible to take the credit?
Basically a qualifying person is a dependent under age 13 unless disabled, then there is no age limit. A qualified individual is not just a child. Other rules include that the parent must have earned income and if married both must have earned income. The credit is then going to be based off of what they call qualified expenses. Those qualified expenses are basically just the cost of daycare or the cost that you may pay a daycare provider. It qualifies if the expenses are incurred while the parent/guardian works or for the time they are looking for work. This is in the case if the person is unemployed. They can use this credit for any expenses while they are looking for work. Lastly, the childcare provider must give you their name and SSN or EIN.
How can a family take advantage of these tax savings?
There are two ways. The first way is that they can take a tax credit on their tax return. The second way is they can utilize their employer sponsored cafeteria plan—the Section 125 plan. I see that a lot of people do a combination of both.
How much can someone save by taking the credit?
It really varies widely depending on income level and whether you take advantage of any employer plans. If you take the credit, it can be between 20 – 35% of the qualified expenses paid. Qualified expenses are limited to $3,000 for one child and $6,000 for two or more children. So 35% credit on $6,000 worth of expenses gets you a pretty nice number.
You said people can take advantage of an employer plan?
Yes, usually the Cafeteria plan (Section 125 plan) is the better way to go. If you use the credit, it’s only a credit against your income tax. Like I said, it’s somewhere between 20% and 25%. If you use the Cafeteria Plan, you can actually reduce your taxable income by not only the income tax, but also Social Security and Medicare. Many times the Cafeteria plan is the better way to go assuming your employer offers the plan and you are able to run these expenses through. It is also nice that it’s not limited to $3,000 if you have one child. With the Cafeteria Plan, you can reduce your income up to $5,000 (no matter how many children).
Is there planning that can be done ahead of time?
Yes, there is. It really depends on your income level. From our calculations, the lower your income level is, the better it may be to take the credit. The higher your income level is, the better it is to take the Cafeteria Plan from your employer. It’s nice because it is a pretty easy calculation, and people should do it because many are leaving a lot of money on the table.