Picking the right tax break for dependent care
For those who have to pay someone to care for a dependent so they can work, there’s help in the Tax Code – provided they can figure out which program works best for them.
Right now, taxpayers can choose between two programs with overlapping requirements and benefits -- the Dependent Care Assistance Program and the Dependent Care Tax Credit. Moreover, there are two more possibilities in the administration’s pending tax reform proposal.
While the requirements for the DCAP and the DCTC are similar, the use of one might limit or preclude the use of the other, according to Stephen Smith, relationship manager at National Benefit Services.
“It is crucial to understand how these programs work, their similarities, and their differences to determine which one will provide the greatest benefit,” he said. “Both the DCAP and the DCTC require the taxpayer and the spouse to be gainfully employed when expenses are incurred for the expense to qualify,” he said. “Looking for work, being a full-time student or being incapable of self-care are considered to be gainfully employed.”
The taxpayer and their spouse can claim expenses during the year for the lesser of the taxpayer’s earned income, the spouse’s earned income, or the dependent care expenses incurred during the year. “With annual day-care cost usually exceeding $6,000, this normally means that to claim the full amount for the DCAP or the DCTC, both the taxpayer and spouse must individually make at least $6,000,” Smith said.
Qualified expenses must be primarily for care and not to learn a skill, Smith indicated. “The one exception to the primarily-for-care rule is pre-school, which is considered primarily for care even if education is the actual primary reason for pre-school. Ineligible expenses include any school for kindergarten and above, care that is for non-gainful employment reasons. The individual receiving the care must be the taxpayer’s child and be under 13 when the expense was incurred.”
Under the DCAP, employees can elect to have up to $5,000 excluded from their gross income during the year. “A DCAP is generally funded through a salary deferral as part of a cafeteria plan, but it doesn’t have to be,” said Smith. The employer can provide money for employees as an employer contribution, make payments to third parties, or provide a day care facility, he explained.
Under the DCTC, the taxpayer receives a 20-35 percent credit for up to $3,000 in expenses for one qualifying person and $6,000 for two or more qualifying persons.
“Although there are many variables to determine what benefit is best for an individual taxpayer, there are some broad rules for when the DCAP will be better than the DCTC,” said Smith. “Generally speaking the higher your AGI, the more likely DCAP is better for your situation. And if you only have one qualifying individual, the DCAP’s higher maximum of $5,000 versus $3,000 is more likely to work in your favor. If the taxpayer’s state has an income tax, the DCAP will normally reduce the taxpayer’s state income tax liability, while the DCTC will not,” he noted. “Also, higher marginal rates reap a greater benefit for the DCAP, while the DCTC is only based on AGI.”
In many situations, it is possible to claim both the DCTC and the DCAP, he observed. For example: “Employee Z is single and has two children in day care, with an annual cost that exceeds $6,000. Z determines that DCAP will be a better value for her, so she elects to exclude $5,000 through her employer’s DCAP. Because Z has two qualifying individuals, she can claim the difference of the DCTC maximum for two qualifying individuals and the DCAP maximum on her taxes, which means Z can exclude $5,000 through DCAP and claim $1,000 in expenses on her return for the DCTC.”
The Trump tax reform proposal has two additional dependent care benefits, according to Smith. “The first is a tax deduction for anyone that makes less than $250,000 -- $500,000 if married – with the deduction amount pegged to the average cost of child care in the state based on the age of the child. The second is a Dependent Care Savings Account, where families can make a tax deductible contribution up to $2,000 per child on an annual basis to pay for current or future day-care expenses, private school tuition and after-school enrichment programs.”