It’s natural to want the best care for your children and dependents. Fortunately, you can save money on daycare expenses without sacrificing quality. If your employer offers a dependent care FSA plan, your contributions can lower your taxable income. In addition, the dependent care tax credit can cut down your taxes due when you file. Here are the details on each and tips on using both simultaneously.
A financial advisor can help you create a financial plan for your family’s needs and goals.
What Is a Dependent Care FSA?
A dependent care FSA is an employer-sponsored account you can deposit pre-tax dollars from your paycheck into to pay for dependent care expenses. Generally, care expenses for children under age 13 and minors or adults unable to care for themselves qualify for this account.
Like contributions to a 401(k) or healthcare FSA, dollars go into your dependent care FSA before taxes, lowering your taxable income. In addition, the federal government limits these contributions to $5,000 per year for joint and individual filers and $2,500 for those married filing separately. Although these amounts temporarily changed in March 2021, the government reinstated the limits going into the 2022-2023 tax year.
Benefits of Dependent Care FSA
Contributing to a dependent care FSA has significant benefits, including:
- Federal and state tax advantages. Since you deposit pre-tax dollars into the account, you reduce your taxable income and can even drop a tax bracket, depending on your financial circumstances.
- Your dependent care FSA deposits allow you to pay for childcare up front and structure your budget more efficiently.
Drawbacks of Dependent Care FSA
Unfortunately, dependent care FSAs also have pitfalls, such as:
- Money in your account does not roll over. As a result, you have the current tax year to use FSA dollars for eligible expenses. If money is left over at the end of the year, it doesn’t carry over to the next year.
- If your employer doesn’t offer this account, there is no other way to get one.
- Your FSA can only pay for qualifying expenses, while you’re working.
- Leveraging your FSA will likely require you to keep receipts, manage reimbursements and pay for ineligible expenses like childcare for nonwork-related purposes.
What Is a Dependent Care Tax Credit?
The dependent care tax credit is a tax benefit based on childcare expenses. Like dependent care FSAs, the dependent care tax credit is for care expenses for children younger than 13 plus minors and adults unable to care for themselves.
For the 2022-2023 tax year, you can claim $3,000 in expenses for one dependent or $6,000 for two or more dependents. Qualifying expenses include those you paid for someone other than your spouse or the child’s parent to care for your dependent while you worked or looked for work.
A portion of the expenses ranging from 20% to 35% will apply to your tax refund. Typically, this percentage results in a tax credit of $600 to $1,050 for taxpayers with one dependent and $1,200 to $2,100 for multiple dependents. High-income individuals and families will receive less benefit from the tax credit.
Benefits of Dependent Care Credit
The dependent care tax credit helps taxpayers in the following ways:
- When filing your tax return, you can reduce your taxes due by a specific amount.
- Even if you earn significant income, this credit will reduce your taxes (although the benefit will be smaller than that of a family with a more modest income).
Drawbacks of Dependent Care Credit
Although the dependent care credit benefits working families, it has the following disadvantages:
- You can’t claim expenses beyond $3,000 for one dependent or $6,000 for multiple dependents.
- Other than for the 2021 tax year, the credit is not refundable, meaning it can’t increase your tax return. It can only reduce the taxes you owe.
- Your income affects how much you’ll benefit from the credit.
- You pay your taxes and childcare costs throughout the year without assistance.
Can You Use Both Dependent Care FSA and Dependent Care Tax Credit?
You can use a dependent care FSA in conjunction with the dependent care tax credit. However, the same dollars can’t count for both benefits. For example, let’s say you pay for childcare for one dependent so you can work full-time. You put $5,000 into your FSA and also pay $4,000 out of pocket for childcare.
As a result, your FSA contributions lower your taxable income. Plus, when you file taxes, you can use up to $3,000 of your out-of-pocket expenses not paid by your FSA to lower the amount of taxes you might owe.
Dependent Care FSA vs. Dependent Care Tax Credit: Which Is Right for You?
If your employer offers a dependent care FSA, you will likely benefit by contributing to it. You’ll lower your taxable income and pay for dependent care simultaneously. Reducing your taxes up front is usually more beneficial because the dependent care tax credit lowers your taxes due but doesn’t increase your refund.
Plus, dependent care will probably cost you more than $5,000 annually. So, you can claim out-of-pocket expenses for your dependent care tax credit, taking advantage of both tools.
Bottom Line
Working parents and caregivers have two tax-advantaged options for care-related expenses. Generally, the dependent care FSA is more helpful because it reduces your taxable income instead of your potential taxes due. However, your employer must offer the dependent care FSA for you to access it. On the other hand, any working caregiver can apply for the dependent care tax credit when they file. Combining the benefits of both can mitigate the financial burden of paying for dependent care and lower your taxes.
Tips for Dependent Care FSAs and Tax Credits
- Navigating your dependent care expenses optimally isn’t always obvious. Taxes are complex, and everyone’s financial circumstances are different. A financial advisor can help you create a plan to pay for dependent care expenses in the most tax-advantaged way. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Parsing out qualifying expenses and dependents can be challenging. To ensure you make the most of your tax return, use this guide on the IRS rules and exceptions for claiming tax dependents.
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