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Interplay of FSA and Tax Credits with Children

I recently listened to a podcast and saw a question on a forum about the interplay of the child tax credit, along with the dependent care tax credit and dependent care flexible spending account; and how all of these interact.

This is a confusing enough subject on its own, and the information I heard on the podcast was incorrect, so I’m looking to set that straight. Many have the question: “am I utilizing these to the full potential?”.

Let’s dive into what these are.

Two Separate Credits

The first thing to point out is that these are two separate credits: the Child Tax Credit (CTC) is a different credit than the Dependent Care Tax Credit (DCTC). These should be looked at separately, and can be used together.

The other thing I will point out is that there were some temporary rules on both of these credits in 2021 due to COVID. They both had some pretty big enhancements in them in order to get more money into the pockets of families.

At this point the enhancements are gone, and the credits are worth less in 2022 than they were in 2021 - and substantially less in the case of the DCTC.

Child Tax Credit

The CTC is a little more easily understood than the next credit I’ll talk about. The COVID rules allowed for a maximum credit of $3,600 depending on the age of your child; now age is irrelevant, and the maximum credit available is $2,000.

If your child lived with your for at least half of the year, was under 17 as of year-end, you provided half of their financial support and you made less than $200k with the filing status as “single” ($400k if “married filing jointly”), then you would get the full credit of $2k per child.

If you made more than the income mentioned above, the amount of the credit would start to lower (or “phase out”), depending on how much more you made.

This credit is pretty straightforward, and really the only planning item I can think of is if you have high income, you may find ways to lower your income to stay within the phase-out range. Or, if you are married and file a separate return, there may be ways to work together to maximize this credit. You do not lose this credit solely due to filing a separate return from your spouse.

The IRS has a pretty broad definition of who is considered a “child” and includes foster, step and half children and even includes brothers or sisters. As long as you’re financially supporting them and they are under 17, they can be claimed for this credit.

If a dependent of yours isn’t considered a child, you’ll be looking at the Credit for Other Dependents which is a reduced credit relative to the child tax credit.

Dependent Care Tax Credit & Dependent Care Flexible Spending Arrangement (DCFSA)

Here lies some much bigger confusion: utilizing a Dependent Care Flexible Spending Arrangement through your employer, and how that interplays with utilizing the Dependent Care Tax Credit.

I’ll start by saying both the credit and the flexible spending arrangement can only be used if both spouses have income. There are small exceptions like one spouse is looking for work or in school, but the general rule is that both need earned income.

A second item to point out is neither the DCFSA nor the tax credit can be claimed on a married filing separate return. If you are filing a separate return to manage your student loan payments, you’ll have to give up this credit - one of the many tradeoffs you'll have consider when balancing lower student loan payments vs. higher tax cost (in the form of more taxes and loss of credits like this one).

There is the possibility to contribute $2,500 to the DCFSA if your filing status is married filing separately - but this is only allowed if you lived away from your spouse for at least the last 6 months of the year, and a few other rules. This isn’t a loophole to take advantage of this benefit while still filing a separate return. It is really for those who are separated, but who haven’t legally divorced by year-end. If you contributed to your employer DCFSA and lived with your spouse all year, expect to report that as taxable income when you file your return.

Aside from last year with the COVID boosters, I typically suggest most clients, and especially high income clients, to utilize the FSA instead of the tax credit. That is because you cannot use both of them for the same dollars, and there are some pretty serious limitations on the tax credit.

Unless you make less than $43k of income, your credit will be worth 20% of your dependent care expenses. The most you can claim as expenses is $3k if you have one dependent and $6k if you have more than one dependent (if you have 50 children, you can still only claim $6k). This results in a maximum credit value to you of $1,200 ($6k x 20% = $1,200).

Next, let’s think about the DCFSA. There is an annual contribution limit of $5k if you’re single or filing a joint return; and $2,500 if you’re married and filing a separate return (and this is only beneficial if you are separated from your spouse but still considered married, as discussed earlier).

The DCFSA allows you to put money in an account on a pre-tax basis, which can later be used to reimburse your dependent care expenses, as opposed to reporting the expenses on your tax return and getting a 20% credit.

To determine which is better for you, you have to determine your marginal tax rate - if you save more than 20% in tax by putting pre-tax money into a DCFSA, then this is more beneficial than a 20% credit on your expenses.

For many of my high income clients, this includes avoiding taxes like:

- Medicare tax of 1.45%

- Additional Medicare tax of 0.9%

- Federal income tax of at least 24%

- Probably state tax, but I’ll let you determine that

- If your income isn’t more than the social security wage base of $160,200 in 2023, then you may also avoid 6.2% on social security taxes

This pretty quickly adds up to more than 20% and makes the DCFSA the preferred method to pay for child care.

As I mentioned, these cannot both be used on the same expenses. So the typical way this goes down on a tax return is that you claim $6k of child care costs, but because you utilized the DCFSA for $5k, that subtracts from those child care costs in regards to the tax credit.

Even if you reported $11k of childcare expenses for two children. You may think “I used $5k of DCFSA, which leaves the $6k available for the credit where I can get the full $1,200”. No. You only get a total of $6k of eligible dependent care costs among all tax opportunities.

$6k is the baseline. If you utilized $5k through the DCFSA, then you can report $1k of eligible expenses for the tax credit, and you’ll get 20% or an extra $200 tax credit on your tax return.

Final Thoughts

It can be pretty hard to write about tax topics because of how many different situations can cause a different result. There is always the “general rule” followed by exceptions to almost anything. This makes the tax code very complicated. And requires me to throw out there: speak to a tax professional before making any changes to your strategy to make sure you're aware of all the different rules.

But, when it comes to dependent care expenses, I suggest comparing your marginal tax rate, including federal, state and payroll taxes, and comparing that to the 20% credit you would get on your tax return. This should help you determine if the DCFSA is worth it.

If you don’t have access to a DCFSA through your employer, then all you need to worry about is reporting it on your tax return for the credit.

Finally, what if you’re paying a nanny under the table to care for your dependent? You should probably learn about nanny taxes so that you’re doing everything above board and able to report those expenses for your own tax breaks.

If you need help with your taxes, I’m here to help.

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