Flexible Savings Accounts vs. Tax Credits
If you’re a working parent with young children or you’re helping to care for an aging relative, you’re probably well aware of how expensive it can be to hire qualified caregivers. Fortunately, there are two tax-advantaged ways to save on dependent care expenses without sacrificing quality.
#1 – Contribute to a dependent care flexible savings account (FSA).
Dependent care FSAs are employer-sponsored savings vehicles that offer employees a tax-advantaged way to save for dependent care expenses. Eligible employees can make pre-tax contributions directly from their paychecks, which can help reduce the employees’ taxable income in the year contributions are made. Contributions are limited to $5,000 per year per household if married filing jointly ($2,500 for single filers).
FSA funds can be used pay for the care of children under the age of 13 and individuals who are unable to care for themselves. Eligible expenses include:
- Daycare for children or adults
- Babysitting and nanny services
- Preschool
- Before- and after-school programs
- Summer day camps
FSA pros:
- Pre-tax contributions lower your taxable income in the year they’re made.
- Disbursements from the account are tax-exempt when used to reimburse yourself for qualified dependent care expenses.
FSA cons:
- FSAs are use-it-or-lose-it accounts. Contributions may be forfeited if not used by the end of the year they’re contributed. While some plans will allow a short grace period, you’ll need to confirm the rules for your plan with your employer.
- These accounts require you to pay for expenses out of pocket, then apply for reimbursement. This means it’s important to maintain receipts and regularly manage your reimbursement requests.
- If your employer doesn’t offer a dependent care FSA, there’s no other way to participate in one.
#2 – Take advantage of dependent care tax credits.
Another way to save on dependent care expenses is by taking advantage of any applicable dependent care tax credits. These credits give you back a portion of the money you spend on dependent care and have the potential to significantly lower your tax bill.
It’s important to note that these credits are different from the child tax credit, which is a tax credit that can reduce a family’s tax bill if there are dependent children under the age of 17 living in the household. In contrast, dependent care tax credits are designed to help working families offset expenses related to the care of dependent children under the age of 13 or a dependent adult with a disability.
Families can claim up to $3,000 in dependent care expenses for one dependent or up to $6,000 for two or more dependents. Based on your particular situation, 20% to 35% of these expenses will apply to your tax refund. This typically results in a tax credit of between $600 and $1,500 for families with one dependent — and a credit of between $1,200 to $2,100 for families with multiple dependents. Tax credit benefits are typically lower for high-income individuals and families.
Qualifying dependent care expenses include:
- Preschool
- Before- and after-school care
- Care provided by someone outside your home
- Day camps
- Transportation to and from a care provider’s location
- Certain fees paid to care providers
Dependent care tax credit pros:
- Proper use of the dependent care tax credit can result in significant tax savings.
- Even if you’re a high-income household, you can likely qualify for tax savings. (However, the benefit you receive will likely be smaller than those for lower-income households.)
Dependent care tax credit cons:
- The amount you can claim in expenses is limited to $3,000 for one dependent and $6,000 for two or more dependents.
- The tax credit is only available at the end of the year, which means you’re responsible for covering the costs of dependent care as you incur them throughout the year.
- The tax credit isn’t refundable, which means it doesn’t increase your potential tax refund — it only reduces the amount of taxes you owe.
Combining the two strategies
Fortunately, you can use both a dependent care FSA and the dependent care tax credit. However, you can’t claim the same dollars for both benefits.
If your dependent care expenses exceed $5,000 in a given year, you can set aside the first $5,000 in a dependent care FSA and use the excess out-of-pocket care expenses to qualify for dependent care tax credits.
For example, if you pay $10,000 a year in dependent care expenses for your three children, you can contribute $5,000 to a dependent care FSA and claim the remaining $5,000 as a tax credit (because it’s less than the $6,000 maximum for multiple dependents).
Could you use some help implementing these dependent care tax-saving strategies? Creative Planning is here for you. Our experienced teams take time to get to know you, your current financial situation, your goals for the future and any challenges you may face before offering well-informed, custom solutions to meet your needs. For more information, please schedule a call with a member of our team.
