Key Points

• The Dependent Care FSA contribution limit was increased to $10,500 and, for a limited time, unused funds can now be carried over into future years.

• Qualifying childcare expenses used towards the Child and Dependent Care Credit was expanded to $16,000, and the percentage of expenses that are eligible for the credit was increased to 50%.  

• Some families may be able to utilize both the FSA and the Credit, but most families will have to decide which one is more beneficial based on their childcare expenses, income, and overall tax bracket.

To help families during the Covid-19 pandemic, Congress enacted the American Rescue Plan, making sweeping changes to both the Dependent Care FSA (Flexible Spending Account)and the Child and Dependent Care Credit.

While some families may be able to utilize both the FSA and the credit, most will find it more beneficial to utilize one over the other depending on the level of their childcare expenses, income level, and tax bracket.

The Childcare Challenge

According to Care.com’s 2021 Cost of Care Survey, more than half of families (57%) surveyed spent over $10,000 on childcare in 2020, and 59% plan to spend more than $10,000 in 2021.¹ While this is a staggering amount of money , we see that childcare costs vary widely between states. In Illinois, for example, the average annual cost of infant care is slightly less than $14,000, while childcare for a 4-year-old costs almost $11,000 per year.² The rising costs from increased Covid-19 safety protocols at childcare facilities have only exacerbated the problem.

$5,500 Increase in Dependent Care FSA and Carry Over

A Dependent Care FSA is an employer-offered, pre-tax savings account that can be used to cover qualified, out-of-pocket dependent care expenses. The contributions you make not only escape federal and state taxes, but also payroll taxes, commonly referred to as FICA taxes (Social Security and Medicare).

The American Rescue Plan changed the 2021 dependent-care FSA limits from $5,000 to $10,500. For an Illinois taxpayer in the highest tax bracket, maximizing your Dependent Care FSA could save you over $4,400 in taxes. Additionally, with the introduction of the Consolidated Appropriations Act, employers can now allow employees to carry over all unused funds from 2020 to 2021 and from 2021 to 2022.³

Dependent Care FSA Eligibility

Although the Dependent Care FSA allows for significant tax savings, not all taxpayers are eligible to participate in this type of plan. Those who are eligible will need to follow specific rules to ensure that their expenses are qualified.

Obviously, your employer will first have to offer this fringe benefit. If they do, you’ll then need to make sure that Dependent Care expenses are incurred because you (and your spouse if married) are currently working or are looking for work. The dependent care expenses incurred must also be for the care of a dependent under age 13 or a dependent who is mentally or physical incapable of caring for themselves. Note that both spouses must have earned income and that the maximum amount you can contribute is based on the lower of the two incomes.

Up to $16,000 of Expenses Towards the Child and Dependent Care Credit

The Child and Dependent Care Credit is a tax credit that working individuals can use to offset the cost for the care of eligible children and other dependents.⁴ Since it’s a tax credit and not a tax deduction, taxpayers will receive a dollar-for-dollar tax reduction.

The American Rescue Plan changed the amount of qualifying expenses from $3,000 to $8,000 for one qualifying person and from $6,000 to $16,000 for two or more qualifying persons. The percentage of qualifying expenses eligible for the tax credit increased from 35% to 50%. This means if you have qualifying expenses of $16,000, you’d receive an $8,000 credit. What’s even more beneficial is that the credit is fully refundable, meaning you’ll receive the credit even if you have no tax liability. Lastly, the beginning of the reduction of this credit has been increased from $15,000 to $125,000 of adjusted gross income.⁴

Child and Dependent Care Credit Eligibility   

Not all taxpayers will be eligible to claim the Child and Dependent Care credit. You can claim this credit if you pay for the care of qualifying persons so that you can work or if you are looking for work if recently unemployed. Again, a qualifying person is a dependent under age 13 or a dependent who is mentally or physically incapable of caring for themselves. Both spouses must have earned income unless one spouse is recently unemployed and looking for work, disabled, or a full-time student. Note that the eligible expenses for this credit will be based on the lower of the two spouse’s income.

Everyone’s situation is slightly different and these decisions should align with your entire investment strategy. As things are rapidly changing, your Capstone advisory team is here to ensure you’re positioned in the ways best for you.

Sources:

¹ https://www.care.com/c/how-much-does-child-care-cost

² https://www.epi.org/child-care-costs-in-the-united-states/#/IL

³ Stimulus Act Raises Dependent Care FSA Limits, Adjusts Tax Credit (shrm.org)

⁴ Child and Dependent Care Credit FAQs | Internal Revenue Service (irs.gov)

Disclosures:

This article is not a substitute for personalized advice from Capstone and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed by other businesses and activities of Capstone. Descriptions of Capstone’s process and strategies are based on general practice, and we may make exceptions in specific cases. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.