Childcare is expensive.
As a parent of two children in daycare, I’m a huge fan of the expanded tax benefits from the American Rescue Plan.
It personally benefits me. It also excites me that this could make child care more affordable for more young families in 2021.
What changed?
You can read the full text of the American Rescue Plan by clicking here.
This article is focusing on the changes to dependent care expenses. The two changes are related to:
- Dependent Care Flexible Spending Account (DCFSA from here on)
- Dependent Care Tax Credit (DCTC from here on)
What is the DCFSA?
The DCFSA is a tool to contribute pre-tax dollars into an account earmarked for the use of child care expenses. You can learn more about what qualifies by clicking this link.
To contribute to a DCFSA you need to make an election during your benefit plan open enrollment. You elect how much you want to defer to your DCFSA for the year.
Every dollar you contribute goes in Federal+State income-tax-free AND Social Security+Medicare tax-free.
Effective for 2021 DCFSA contributions were increased to $10,500 from $5,000. Whether you have 1 child or 10 children, the limit doesn’t change. All you need are eligible expenses to take the money out within the calendar year (or before March 15th of the following year in some cases).
What is the DCTC?
The DCTC is a tax credit families receive based on how much they paid in child care.
Tax credits are a dollar-for-dollar reduction of taxes. If you normally receive a refund, then you would see a credit like this increase your refund.
The DCTC is calculated after considering your DCFSA contributions. If you don’t contribute anything to your DCFSA, then all of your related expenses (up to a maximum threshold) are eligible for the DCTC.
Effective for 2021, the DCTC, is available for the first $8,000 of eligible expenses ($16,000 for 2+ kids). This increased from $3,000 of eligible expenses ($6,000 for 2+ kids).
To calculate your DCTC you multiply your eligible expenses (up to the max) by your “DCTC rate.”
Under the old law after you had $43,000 of AGI your credit was limited to 20%. Under the new law, the first $125,000 of AGI receives a credit of 50%!
Here is a handy chart to summarize what this means:
Should I use the DCFSA or DCTC?
If you do not have access to a DCFSA, then you will take the credit.
For anybody who has the choice to use the DCFSA and/or the DCTC then you should run the numbers to find what is best.
That’s why I created this free tax savings calculator:
The hard part is knowing your Federal and State marginal tax rates.
The quickest way to find your federal marginal rate is to use the free Tax Bracket Manager calculator.
The next decision you have to make is to identify where your AGI might fall in 2021. The tax planning calculator above will answer that too.
An interesting planning point is how valuable will the DCFSA be in getting you to a lower AGI in 2021. If you choose to forego the DCFSA after using it in the past, then your AGI will go up. If your AGI goes up, then you might be phased out of this or other credits like the Child Tax Credit.
The easiest remedy would be to increase your 401k contribution to reduce your AGI back down. This might not be possible if you can’t make it work with your cash flow or are already maxed out.
Is there any rule of thumb?
Under the old rule if you were in the 22%+ tax bracket you were probably better off using the DCFSA than DCTC. I say probably because your state income tax matters too.
It’s a lot closer race this time, with the credit winning more often.
I always prefer running the numbers for your situation. Yet, as I worked through the child tax credit calculator, here are a few observations:
- If your AGI exceeds $400,000 then max the DCFSA
- If your AGI is between $185,000 – $400,000 then probably max the DCFSA
- If your AGI is $125,000 or less then skip the DCFSA
- If your AGI is between $125,000 and $185,000 then run the numbers.
- I’m a fan of ease, so the DCTC wins that by a long shot.
- I’m a fan of having more money now than later, so the DCFSA wins there but let’s be honest…. the time value of money for a few months isn’t worth much these days.
Run the numbers and see what’s best for you.
I am confused easily with the scenario, admittedly.. however I keep going back to a step I believe is being neglected in the DCTC scenario which I see is strongly recommended over maxing out a DCFSA, for most people. Take for instance a family of 2 kiddos with AGI under $125k=DCTC eligible expenses of $16000 w/50% credit. While this seems to be a total of a $8000 credit… it doesn’t take into account that the $16000 that was paid for child care began as taxable income (not so with a DCFSA)- which would effectively lower the final credit amount if using the DCTC. For example if your combined tax rate (fed marg, state, FICA, Medicare) is 35%, that $16000 had $5600 of tax imposed before becoming net pay.. thus lowering the total credit to $2400 ($8000-$5600) after taxes. Is my logic off?
Hi Katie
Thanks for the response. You can test out this situation using our DCFSA vs DCTC calculator.
Based on your example, the couple would save $3,675 in taxes (35% * $10,500) by funding the DCFSA. By contributing $10,500 to the DCFSA the eligible expenses for the DCTC drops to $5,500 ($16,000 – $10,500). After that you calculate the tax credit based by taking the REMAINING eligible expenses multiplied by the credit rate, which is 50% in this case. Ultimately the DCTC equates to ($2,750).
The calculator will paint a better picture than my words. 🙂
I think the potential misstep in your example is that you gave $16,000 the full benefit of the tax savings. Unfortunately, that’s only a threshold to start the calculation with.
I appreciate your question. If I didn’t explain anything well here, I’ll gladly follow-up to any questions or comments.
Have a great day!
Hi again and thanks for the reply! I’m still confused, though, and could use some further insight. I think I failed to say that (in the example situation) my personal math leads me to believe it would be more lucrative to max out the DCFSA @ $10500, then to also claim the remaining eligible expenses ($5500) under the DCTC. Keeping in mind, this remaining $5500 is not pre-tax deductions like the monies with the DCFSA- rather, it is taxed @ 35% as it is taxable income before paying for the care expenses.
This confuses me as EVERYTHING I read… all posts, blogs, calculators, etc., advise it would be better for the majority of people to just take the full DCTC and avoid DCFSA contributions at all for 2021. Every site keeps saying the DCTC @ a $8000 dollar for dollar credit is much more than you would get through increasing DCFSA contributions. However, as above, his info doesn’t seem to take into account that the credit is based off of money (up to $16000) that one paid to daycare after it was taxed from the paycheck…. plainly, the $8000 credit is before those taxes are deducted.
Let me lay out my thoughts, and then please, please, please do let me know what I may be missing, as I’m certainly not a tax expert… just a parent looking or the right choice here. 🙂
My thoughts are based on maxing out the DCFSA @ $10500, then claiming the remaining eligible expense of $5500 under the DCTC:
If one were to max out DCFSA contributions of $10500, at the example tax rate of 35%, the savings would be $3675 for this benefit alone. The DCTC at this point would be $825 for the remaining eligible $5500 amount, as it was taxed initially:
$5500*.35=$1925 total tax, the credit being 50% of eligible expense ($5500*.50= $2750) then, finally the credit minus this tax paid upfront: $2750-$1925= $825. The savings amount when combining the two benefits would be a total savings of: DCFSA $3675 + DCTC $825= $4500.
Choices per my math based on a combined 35% tax rate:
1. Solely maxing out the DCFSA @ $10500 would be a savings of $3675, with DCFSA deductions being pretax savings. Or:
$10500*.35= $3675 savings (also reducing total taxable income)
2. Solely claiming the DCTC on a max of $16000 eligible expense, with a 50% credit rate, would be a total savings of $2400. The $16000 paid to childcare centers not being pre-tax deductions, is taxed upfront (35% in this case) with this tax reducing your net credit. OR:
$16000*.35= $5600, this subtracted from the $8000 credit: $8000-$5600= $2400
3. Combining by maxing DCFSA to $10500 and claiming remaining eligible $5500 under DCTC would be a total savings of $4500. Or (as above):
DCFSA $3675 + DCTC $825= $4500.
Again… not sure why everything says claiming the DCTC is a better choice. Am I off?! Thank you!!
Hi Katie
I appreciate you reaching out to clarify your thoughts. Let me try to help out using your same example. Two qualifying dependents with $16,000 of expenses. Here we go:
Option 1: Do nothing.
If you do nothing and have the income and expense scenario above, then you will receive an $8,000 tax credit.
The parents paid $16,000 out of pocket, but received an $8,000 tax credit. Net cost of care = $8,000.
Option 2: Fund DCFSA. In this case fund it to the max of $10,500.
If you fund the DCFSA you will avoid paying FICA (6.2% Social Security + 1.45% Medicare) + Federal Income Tax Expense (22%) + State Income Tax expense (5.35% is the “plug” to get the total to 35%). You receive this benefit immediately since it’s reflected on each paycheck.
The $10,500 contribution is worth $3,675 of lower tax. By funding the DCFSA you have less expense eligible for the DCTC. The remaining DCTC eligible expense is $5,500, which translates into a $2,750 tax credit. Combined tax benefit = $6,425.
The parents paid $16,000 out of pocket, but received an $6,425 tax benefit. Net cost of care = $9,575.
Another way to think about it is that the most you will save on childcare is $8,000. The tax credit sets the max benefit. If you try this out on the calculator, you’ll see that even if you are at a combined 60% federal and state tax rate (too high for current law) the max savings is at $7,100.
It might help to think about it as one of the two options. It’s either the DCTC or the DCFSA and whatever is left to take as a DCTC.
If this isn’t helpful, send me an email: curious and calculated at gmail dot com
Thanks for the article and interesting discussion with Katie,
Our situation is similar, but a bit different in some important ways. We have been managing daycare on our own during the pandemic with the help of other family members. With both my wife and I being called back at least partially to the office, we will start day care shortly for our youngest daughter (about to turn 1). We expect her daycare to be about $8,000 or so for the remainder of the year. Our other daughter is a full-time student.
Last year I set the Dependent Care FSA (DCFSA) account to max out at $5,000. When researching how to get reimbursement for these funds and whether to increase the withholding to the new max of $10,500, I found out about the Dependent Care Tax Credit (DCTC). The DCTC would be the better option but I can’t reduce the $5,000 DCFSA amount. However, any amount unused can be carried over into 2022.
Could I not use any of the DCFSA amount, allow it all to carry over to 2022 (we will still need it then), and then claim the full $8,000 of expenses for a $4,000 tax credit? Or because the $5k is already being set aside can I only qualify for $3k of expenses for the DCTC?
We had also thought about maxing out the DCFSA to the new $10,500 level since, assuming the 2021 changes are temporary, we would still need the funds for daycare in 2022 (we estimate that at about $16-18k per year). If we max it out, but don’t use all of it, would that affect our ability to claim the DCTC?
Or are we better off sticking with the $5k DCFSA and then claiming a $1.5k (50% of the remaining $3k of expenses) DCTC for 2021?
thanks for your advice,
– Raf
Our AGI was $117k last year and it should not change much this year.
Hi Raf
Thanks for the message.
My employer chose not to follow the American Rescue Plan’s rules around the DCFSA too. I’m stuck with whatever decision I made in November 2020. Boo!
In the Tax Bracket Manager I ran a calculation to see where you might fall for a federal tax bracket. If your AGI of $117,000 doesn’t include any capital gain income, then you are in the 22% tax bracket. The Bracket Breakdown shows you with $10,850 of room within the 22% bracket. This is important for later.
You can check it out here yourself. You would want to enter your 2020 tax return information and adjust for any changes into 2021 to make sure.
With that information in hand you can look to the DCFSA vs DCTC credit using this calculator. Assuming the estimate I referenced above is accurate, you would enter 22% for the federal income tax. For your state you will need to estimate what that would be. Most states get you to the top 1-2 tax brackets by the time you hit 100% of AGI, but I can’t guarantee that.
With that go ahead an look at the comparison between the DCFSA and DCTC only. If you are stuck with $5,000 of DCFSA in 2021 and pay a 22% federal tax rate plus a 5% state tax rate, you’ll see a tax benefit of $3,232.50 versus $4,000 had you only pursued the DCTC.
Remember when the Bracket Breakdown showed $10,850 of room within the 22% bracket? That’s important because that means if you can increase your DCFSA to $10,500 you will see all of those dollars deducted within the 22% bracket.
Now you can update the DCFSA vs DCTC calculator and you’ll see that the gap shrinks between the DCFSA and DCTC. Now the DCFSA is up to $3,638.25.
It’s still less than the DCTC by itself. However, if you’re stuck with the DCFSA anyway then contributing more to the DCFSA is compelling!
Another potential benefit of contributing more to the DCFSA in 2021 is that you could potentially deduct more of your IRA contributions. You’re in the phaseout range before the DCFSA contribution so more dollars into the DCFSA will create more room to deduct more of your IRA contributions. The IRS lists the income limits here: https://www.irs.gov/retirement-plans/2021-ira-deduction-limits-effect-of-modified-agi-on-deduction-if-you-are-covered-by-a-retirement-plan-at-work
Otherwise, the idea of carrying it forward as long as you know you can use it all is valid. The choice to fund the DCFSA again next year will depend on whatever next year’s rules and your projected tax numbers are.
I hope this helps.
Have a great day!
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Curious if you can help me make sense of this:
I paid $3,000 in daycare expense prior to starting a new job in April, and I signed up for the DCFSA for $5000. (Before learning of the extended DCTC, of course)
I have since submitted $3700 in expense for the pre-tax reimbursement on the DCFSA. The remaining daycare expense I anticipated for the year of $1300 will not be reached due to labor shortages and no available daycares/after school programs for my son at this time.
Can I claim the initial $3000 daycare expense under the DCTC for the 50% reimbursement, or do I need to take the $1300 DCFSA portion out of that amount before claiming it? I’m unable to claim prior to my job start date under the DCFSA, and I won’t meet the $1300 amount even if the after school program is able to hire an employee soon and move my child off the current wait list.
Is there any remedy here to lessen the $1300 loss of unclaimed DCFSA?
Hi Jen
Sorry to hear about your childcare conundrum. With a DCFSA you can stop contributing to the account when a “qualifying life event” occurs. This means, when your child was no longer eligible for care you could stop contributing to the DCFSA. A Qualifying Life Event includes a “change in care provider, change in cost, or change in coverage.” It seems clear you qualifies for a change in provider!
I had this happen with me a few years ago. My HR department allowed me to stop contributing AND reimbursed me for the over contribution. I don’t recall the numbers but I was a few hundred dollars over what I would be able to reimburse and they simply “refunded” me an amount. The way I remember it working is that I contributed $208 per paycheck. The qualifying event happened on X date. Therefore, any contributions I made from that point forward I was able to receive a “refund.”
I can’t guarantee your HR will comply. Issues like this might be discretionary versus required. Custodian rules are a different beast.
Otherwise, does your employer support the grace period? This means any expenses incurred in early 2022 could be reimbursed from those contributions.
Whether you use your DCFSA or not, it will reduce the amount of your eligible expense for the DCTC. When you deposit funds into the DCFSA you receive the immediate tax savings. This is why once it’s in the DCFSA your eligible expenses for the DCTC is reduced.
Could you hire someone unrelated to you to watch your child to use up the funds? This person could serve as your care provider to use up the funds. They’ll need to provide you their SSN so you can report it on your tax return and request reimbursement from your employer.
This is something I hate about FSAs (dependent and health). You should lose these dollars. Unfortunately, their rules are horrible and puts you at risk.
If I think of anything else I’ll let you know.
In the meantime, good luck and give HR a call about your life event. Push them hard on it!
Hi, do you have a 2022 version?
Hi Erin
Not currently. I’m waiting for the updated tax bill.
All signs point to only a $5,000 DCFSA for 2022. My opinion is to run the numbers based on that assumption.
I’ll let you know when I update the article.
Thanks!