How to use your kids to save on taxes

Choosing between a Flexible Savings Account for dependent care and the Household and Dependent care Tax Credit

You might have seen this person before. A stressed out parent who seems to be juggling 20 things at once. For those of us with children who have to work outside of the home juggling all of the various tasks, chores, and responsibilities can be complicated, and down-right frustrating sometimes. Our elected representatives in the federal government know that having children is both important for the future of our country and a financial burden. So to try to compensate for those loads a few different programs have been created to help. However, in the typical IRS style, it is not immediately obvious as to which option is the best for a given taxpayer in any particular situation.

There are two options that will be discussed here. One is a flexible spending account (FSA) dedicated specifically for dependent care. There are also Flexible Healthcare spending accounts (HSA) which is a similar yet totally separate issue. The second one is the Household and dependent care tax credit.

Flexible Spending Accounts (FSA)

This type of account uses pretax income to pay for qualified child and dependent care expenses. That means that certain expenses (nanny’s, daycare, afterschool programs, etc) that are necessary for a parent or caregiver to work outside the home can be paid for with money that is not subject to state or federal income tax, nor is it subject to social security and medicare taxes. Here is a practical example: If you report $35,000 in gross wages on your tax return, then your marginal tax bracket is 25%. If you were to put $1000 in pretax funds into your FSA account then you would reduce your taxes by $250. If you compare your pretax cost, that same $1000, if it were paid with after tax money, would really have cost you about $1333 before taxes. So your savings is really 33%.

There are two details to consider with these accounts. You must plan carefully when using these accounts because any funds not used during the plan year could potentially be lost (see the tax rules governing FSAs below.1) FSA accounts have annual limits as to how much can flow through them tax free, which also needs to be taken into account. But the good thing is that any money spend above and beyond the FSA account limit maybe eligible for a tax credit.

Household and Dependent Care Tax Credit

This program is a tax credit. A tax credit is different from a deduction in that it is a direct reduction of the amount of tax you have to pay. A Deduction as described in the previous example lowers your taxable income which then in turn will lower your tax burden, but the amount of the discount depends upon your tax bracket.

There are a number of caveats here as well. The maximum amount of expenses that can be taken as a tax credit is limited to 35% of expenses paid for up to $1050 for one dependent or $2100 for two or more dependents. To complicate it further the % of expenses to credit is on a sliding scale depending on your income as well.

So which on is better?

There are many moving parts and complications such as limits on the particular FSA account, and limits based on the salary of the two spouses that are too complicated to go into in a blog post, but here are some general guidelines as to which one may be a better choice in your situation assuming that the FSA contribution limit is $10,000 per year.

If you have one dependent then the FSA account will almost always be the winner.

If you have two or more dependents, and your adjusted gross income is above $40,000 it is more advantageous you to use a FSA account rather than the tax credit.

If you have two or more dependents, and your adjusted gross income is between $30,000 and $40,000 then it depends upon how much you spend in a given year, and the best thing to do would be to contact your tax advisor. If you spend more than $7150 in a given tax year then it probably would be advantageous to take the tax credit over the FSA account. If you spend less, then the tax credit takes the cake.

If you have two or more dependents, and your adjusted gross income is less than $30,000 then most of the time the tax credit will be more advantageous.

Can you take both the tax credit and FSA?

The tax credit is limited to expenses that are paid with after tax money. This means that any expenses paid out of the FSA account cannot be used to calculate the tax credit, but if you spend more than what you contributed to the FSA then the excess could be used to calculate the tax credit.

The key here is to be conservative in your estimated expenses during the open enrollment period for your given plan.

 

  • However, even though you must incur an expense within the plan year (or within the grace period, if offered), your employer typically will provide a specified period after the plan year ends during which you may submit a claim for an incurred expense (usually 90 days beyond the plan year, but check with your employer for the exact date).
  • The IRS defines “incurred” as when the service was provided, not when you were billed. For example, if your child’s daycare provider bills you at the beginning of each month, you can be reimbursed by your Dependent Care FSA only after you have received all daycare services for that month, not when you paid the month’s bill.

Footnote:

1 – www.Practical money skills.com http://www.practicalmoneyskills.com/personalfinance/lifeevents/benefits/flexspending.php

Tax law source:

CCH Federal Taxation comprehensive topics, paragraph 9015, 2014 Edition