Parents who incur significant expenses while caring for their children may want to know about ways to reduce those costs. They may be able to use the child and dependent care tax credit, or they may want to set up a dependent care account. Read more here about the child and dependent care credit, as well as the basic child tax credit. The discussion below covers dependent care accounts.
While some people will use both the child and dependent care credit and a dependent care account, this is not always a useful strategy. Contributions to a dependent care account are subtracted from the child care expenses that can be claimed under the child care credit. Dependent care accounts generally make sense for people who are in the 24 percent tax bracket or higher. You can seek guidance from a tax adviser for your specific situation.
How Dependent Care Accounts Work
A dependent care account holds tax-free funds that will be used to pay for day care, kindergarten, and other child care costs. If you run your own business, you can create a dependent care account for yourself. Otherwise, you can open a dependent care account only if your employer offers this option. If you are filing your taxes jointly with your spouse, you can contribute up to $5,000 to a dependent care account. If you do not file taxes jointly, you can contribute up to $2,000. (Sometimes employers set lower limits than those provided by federal tax laws.) You should try to avoid putting more money in the account than you may need to cover these expenses. At the end of each year, you will lose any unused money in the account.
The earned income of each spouse limits the amount that they can take out of the account. You cannot take out more than the earned income of either your spouse or you, whichever is less. In other words, you cannot use the account at all if either of you does not work, with two exceptions. First, if your spouse or you is a full-time student, that person will be considered to earn $250 per month, or $500 per month if you have multiple children. The same rules apply if your spouse or you are disabled and unable to handle basic self-care.
You will need to decide whether to open a dependent care account sponsored by your employer during the general benefits enrollment period. When you open the account, you must decide how much money you will place in the account. You will not have an opportunity to revisit this decision. Once you sustain a cost related to child care, you must follow your employer’s policy for getting reimbursement and include this information on your tax return.
Virtually any type of child may qualify for a dependent care account, including biological children, adopted children, stepchildren, or foster children. However, the child must be younger than 13 at some point during the year, or they must suffer from a permanent and total disability. You must cover more than half of the cost of maintaining a home for the child and you during the year, and the child must live with you for more than half of the year. (Travel with you counts as time living with you.)
You must use money from the account only for child care expenses, which can include household services if they were undertaken at least partly for the child’s benefit. Money from the account cannot pay for education, entertainment, and other expenses unrelated to care. However, you do not need to select the cheapest available form of child care.
The child care must have allowed you to work, attend a full-time educational program, or look for a job if you are unemployed. You cannot hire a spouse or a dependent as your child care provider. To verify the information of the care provider, you must provide their name, address, and Social Security or employer identification number on your tax return.