Don't Sleep on the Dependent Care Credit
There’s good tax news — and bad tax news — for parents who pay someone to watch their young children while they are at work. Under the American Rescue Plan Act (ARPA), the dependent care credit for qualified expense was generally enhanced, providing bigger tax savings on 2021 returns. But the revamped credit is completely phased out for some high-income taxpayers. (Under current tax law, the enhanced dependent care credit expires in 2022. But Congress could extend or modify the credit again. We’ll continue to monitor developments.)
How did the credit evolve?
Before 2021, the credit was available for the childcare costs incurred to enable you (and your spouse if married) to be gainfully employed, with the percentage depending on your adjusted gross income (AGI). The maximum 35% was gradually reduced, but not below 20%, by one percentage point for each $2,000 (or fraction thereof) of your AGI exceeding $15,000. For example, if a parent’s AGI was $25,000, the credit was equal to 30% of qualified expenses. After your AGI exceeded the $43,000-of-AGI mark, the credit was equal to 20% of your qualified expenses.
The credit could be claimed for the first $3,000 of qualified expenses of caring for a child under age 13 or $6,000 for two or more under-age-13 children. Therefore, if you had an AGI of $100,000 and paid $10,000 in qualified childcare costs for two children, the maximum credit allowed was $1,200 (20% of $6,000).
But ARPA upped the ante for parents paying for childcare, effective for 2021. Specifically, the new law includes the following provisions:
- The credit is fully refundable (previously, it was nonrefundable). So, you can benefit completely even if the credit results in a refund on your 2021 return.
- The maximum credit percentage jumps to 50% of your qualified expenses, and the limit for qualified expenses increases to $8,000 for one qualified child and $16,000 for two or more children. Accordingly, the maximum credit for 2021 is $4,000 for one child, or $8,000 for two or more children.
- The credit percentage structure is modified. For 2021, the credit is gradually reduced if your AGI exceeds $125,000 until it bottoms out at 20% for an AGI above $183,000, but not above $400,000. Thus, the maximum credit for taxpayers in this range is $1,600 for one child or $3,200 for two or more children — still a pretty good deal.
If your AGI exceeds $400,000, though, the credit is further reduced until it disappears completely for an AGI above $438,000. These taxpayers get no tax benefit from dependent care
Ins and outs
For the most part, the basic rules for the dependent care tax credit remain the same as they were before ARPA. You may even qualify for a bigger credit than you think.
Typically, the credit is associated with out-of-home expenses of parents who drop off their kids on their way to work at a daycare center or nursery school. However, some in-home costs also may qualify for the credit. For example, you may claim for amounts paid to a babysitter who comes to your home, even if the babysitter is a close relative like a parent or aunt or uncle. But the relative can’t be someone who is your tax dependent (such as a teenaged child you pay to watch a younger sibling).
On the negative side, qualified expenses for a married couple can’t exceed the lower of earned income or the annual earnings of the lower-paid spouse. For example, if one spouse earns $5,000 a year working part-time, and the couple pays $10,000 annually to a babysitter to watch the kids, the qualified expenses available for the credit are limited to $5,000 — not $10,000.
Further, if one spouse has zero earned income, you generally can’t claim any credit. However, if the spouse is either a full-time student or is disabled, the spouse is treated as having monthly earnings of $250 for one qualified child or $500 per month for two or more children. Thus, the maximum amount of qualified expenses for the year is $3,000 for one child or $6,000 for two or more children.
Tax credit vs. deduction
It’s important to keep in mind that the tax credit is a dollar-for-dollar reduction of your tax bill and is therefore more valuable than a deduction. We’ll provide updates on this enhanced tax break if there are any significant developments.
This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.
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