Most individuals have a requirement to file a tax return annually, and if you have young children, the likelihood is that you have paid some form of child-care expense throughout the year. If this applies to you, then you may be eligible to enroll in an employer-sponsored cafeteria plan (also known as a Section 125 plan), or you may receive a federal tax credit against your federal tax owed at the end of the year. In order to decide which benefit would be the best option for your situation, you need to know all the details. With either option, it is important to note that, if you are married, both spouses need earned income, and the child must be 12 years old or younger and your dependent.

A cafeteria plan is a benefit that may be provided by your employer. This would allow you to contribute up to $5,000 per year of pretax earnings into a specific, employer-controlled account. This account would then be used to reimburse you for any dependent-care expenses. A cafeteria plan allows you to reduce your gross income, which in turn reduces the amount you pay in federal, Social Security, and some state taxes.

Unless your employer specifically states otherwise, the money in your cafeteria account at the end of the year will be lost. This is an important factor to think about when deciding how much to contribute into this specified account. Another consideration is the cash-flow effect. Your salary is reduced, but you must provide proof of payment of daycare expenses to receive the reimbursement. You want the total amount contributed to not exceed the expenses you pay out throughout the year. This way, you are maximizing the benefits of having this type of plan.

Since the amount you contribute to the cafeteria plan is not included in your wages, you will see a separate line item on Form W-2, Box 10 that states ‘Café 125.’ You would report the W-2 wages as seen on the form, and since you already received a pre-tax benefit from being enrolled in this plan, you may not be eligible to also receive an additional credit on your taxes for the expenses paid through this plan. You are required to file a Form 2441, which is explained later in this article.

If your employer does not offer a cafeteria plan, there is another dependent-care option available in the form of a personal federal tax credit. Similar to the cafeteria plan, this credit has specific guidelines that need to be met in order to receive the total credit. As mentioned above, you must have earned income, which includes wages, salaries or tips, and self-employment income. If you are filing a joint tax return, your spouse must also have earned income. If you are out of work for a period of time but are actively looking for a job, you may still be eligible for the credit.

If you believe the credit may apply, you should provide your tax professional with a list of all applicable expenses. Be sure to note that expenses may include day care or education costs below kindergarten. These expenses are for the care of the child. The credit is equal to 20% to 35% of the total qualified expenses. The percentage of the total expenses that you can deduct depends on your adjusted gross income. The maximum amount of qualified expenses you’re allowed to use to calculate the credit is $3,000 for one qualifying person and $6,000 for two or more qualifying persons. To claim this credit on your tax return, you must complete Form 2441: Child and Dependent Care Expenses and attach it to your Form 1040. On this form you must disclose the name, address, and taxpayer identification number of the individual or organization that is providing the care. It is important to keep supporting documentation in your records in case of an IRS inquiry. If the information is incorrect or incomplete, your credit may not be allowed.

In conclusion, taxpayers with taxable income that is taxed at a rate higher than 20% (married filing joint $74,900, single $37,450) are more likely to obtain greater benefit from a cafeteria plan than taking the tax credit. Another additional benefit of the cafeteria plan is the Social Security tax savings on the amount contributed to the plan. When you receive a credit on your tax return, this also means you are reducing your tax, not receiving an actual refund.

When you are enrolled in a cafeteria plan, you are getting the benefit of reducing your taxable wages before you even begin to prepare your tax return.

If you have any questions, be sure to contact your tax professional.

Rachel Curry is a tax associate with Meyers Brothers Kalicka, P.C.; (413) 322-3488; rcurry@mbkcpa.com

This article can also be found on  BusinessWest.