Revamped 2021 dependent care tax breaks: 6 fast facts for tax preparers

March 8, 2022 10:06 AM

The American Rescue Plan created some major changes to the dependent care tax breaks for 2021, and they will likely save your clients a considerable amount of money. Here’s a quick refresher:

The dependent care flexible spending account

The expense limit for this tax break more than doubled from $5,000 per family per year to $10,500 per family per year.

Note: The change happened in early 2021 (after many families had already enrolled in their company’s cafeteria plan), so some of your clients may have made an adjustment to $10,500 while others may have held their contributions at $5,000.

The Child and Dependent Care Tax Credit (CDCTC)

The expense limit for this tax break increased from $3,000 per dependent (maximum of $6,000) to $8,000 per dependent (max of $16,000). The CDCTC changes for 2021 also increased the credit percentage. In prior years, the vast majority of families were limited to a 20% tax credit based on AGI. For 2021, the tax credit percentage starts at 50% for those with AGI of $125,000 or less and then slides slowly down to 20% for those earning up to $400,000, and it doesn’t phase out until $438,000 in AGI. And finally, this credit is refundable for 2021 tax preparation.

The bottom line: Families with one dependent may save as much as $4,000 this year (up from $600) and those with two or more dependents may save as much as $8,000 (up from $1,200).

Combining dependent care FSA and CDCTC

For the 2021 tax year, more families than usual will be able to use a combination of these two tax breaks. For instance, let’s take a family that contributed $5,000 into their workplace dependent care FSA. If they had one child and total expenses of, say, $17,000, they would be able to itemize up to $3,000 on Form 2441 ($8,000 cap minus $5,000 FSA contribution = $3,000 remaining expenses). If they had two or more dependents, the family would be able to itemize up to $11,000 on Form 2441 ($16,000 cap minus $5,000 FSA contribution = $11,000 remaining expenses).

Eligibility

As in previous years, the person(s) receiving care must be your dependent and be under the age of 13 or mentally or physically unable to care for themselves. Additionally, both spouses must pass the work-related test, meaning the care is needed so they can work, look for work or be a full-time student.

Qualified expenses

Daycare centers, day camps, wages paid to a caregiver, taxes on the wages paid to a caregiver, and fees related to searching for a caregiver are all qualified expenses. Overnight camps should not be included.

Note: In 2021, qualifying expenses were expanded to include “household services” (i.e., housekeepers) if at least part of the services involved the care of a qualifying person.

Reporting expenses and wages

Form 2441 requires that expenses be associated with an EIN in the case of expenses paid to a company (i.e. daycare center) or an SSN in the case of wages paid to an individual caregiver. If wages were paid to an individual caregiver, the family will need to report those wages to their state and the IRS and pay the corresponding employer taxes (i.e. federal and state unemployment, Social Security, Medicare).

Note: Every year, many families find themselves needing to play catch-up on state household employer tax filings. We anticipate this will be especially true this year because of the increased savings.

As you can see, this year, more than any other year, most of your clients will be able to realize meaningful savings on the high cost of dependent care. And for those who hired an individual caregiver, the good news is it’s very likely that their incremental costs to get compliant will be far exceeded by these new savings from the dependent care tax breaks. Unfortunately, many families are unaware of these changes or how to make tax-savvy elections with their dependent care expenses, which makes this a prime opportunity to impress your clients.