Parents can take advantage of several tax credits and exemptions to keep more of their hard-earned wealth working for them while funding their families. The Child Tax Credit, for instance, is a refundable tax credit that can erase one’s whole tax burden if it exceeds the tax liability. There is also the Childcare Credit that provides a tax credit of 20-35% of the first $3,000 in childcare expenses that you pay per child per year.
Dependent Care Accounts allow parents to set aside money from their earnings for various expenses for the care of their children that are free of federal, state, and Social Security taxes. However, parents should calculate their expenses carefully since they cannot use both the dependent care account and the childcare tax credit for the same expenses.
Using the child tax credit and child care credit
Credits are music to one’s ears more so than deductions are. While deductions are subtracted from your taxable income, credits are subtracted from your actual tax. So, if you would otherwise have to pay $1,000 in taxes, a $1,000 tax credit would erase your whole tax burden.
Child tax credit
The child tax credit is a big chunk of change for parents. For 2020, the credit is $2,000 for each qualifying child. The phaseout begins at $200,000 for single and head-of-household filers, and $400,000 for those who are married and filing jointly. There is also a new $500 credit for other dependents.
The additional child tax credit
Another perk: For some low-income taxpayers, the credit is refundable. This means that if it exceeds your tax liability, you will be paid the difference. In other words, if you would otherwise owe $600, you can still get the full credit: the IRS would cut you a check for $1400.
This is called the additional child tax credit. You must fill out IRS Form 8812 to get it, and your earned income needs to be at least $2,500. The refundable limit is $1,400.
The childcare credit
The childcare credit provides a tax credit of 20–35% of the first $3,000 in childcare expenses that you pay per child per year. How much of the 20–35% range you get is determined by your income. The more you earn, the less credit you can take.
To qualify, the children must be under the age of 13 or else permanently and totally disabled.
Another way that the credit is limited is that it can’t exceed the earned income of either you or your spouse. That means that if one of you earned very, very little—say, only $500—that would be the limit of your credit.
Two exceptions exist to this income rule: if one of you has major physical or mental limitations, or if one of you is a full-time student not earning any income. In the latter case, you can get a $250 credit for one child and a $500 credit for more than one.
Do you also have a dependent care account at work? If so, you can use that to pay for expenses, but you cannot claim those expenses for your childcare credit. That would be double dipping, and it is not allowed.
Childcare expenses are figured on IRS Publication 503, Child and Dependent Care Expenses. Be sure to keep all receipts for your expenses.
Dependent care accounts: The basics
Workplaces offer a way for you to save money on your childcare expenses. Dependent care accounts, also called childcare reimbursement accounts, let you set aside money from your earnings for various expenses for the care of your children—preschool bills, daycare, and other expenses. This money is not counted in your earnings for the year and is, therefore, free of federal, state, and Social Security taxes.
You are limited
You are limited in how much you can contribute. The maximum is $5,000 for married couples filing their taxes jointly and $2,500 for married couples filing separately. Also, there is a use-it-or-lose-it provision. The IRS now allows a $500 annual carryover of unused contributions, but if there is money left in the account at the end of the year in excess of this amount, you lose access to it; your company gets to keep it.
That is why you should calculate your expenses accordingly. You must have earned income in order to contribute. If you live on dividends or some other source of money that you did not earn, you are not allowed to contribute.
Why you should plan your expenses carefully
You cannot use both the dependent care account and the childcare tax credit for the same expenses. That would be double dipping, and it is not allowed. But one advantage for you is that if you use up your money from your dependent care account, you may be able to take the credit for expenses incurred beyond that amount, up to the legal limit.
Another important point: the funds you can use from your account are limited by your earned income. This means that you are limited to claiming the lesser of your or your spouse’s earned income. So, for example, if you have $5,000 in the account and you earn $50,000 this year and your spouse earns only $1,000, only $1,000 from the account can be used. The rest will be lost. There is an exception given for a parent who is disabled or a full-time student, but the allowed amount is only $250 for one child or $500 for more than one.
Because of these limitations, it is up to you to forecast and calculate all situations that could interfere with your ability to make full use of the funds you put into a dependent care account.
Not all employers offer dependent care accounts. Those that do will offer them during their benefits enrollment period. This is the time when you will determine how much you want to contribute for the year. You should also receive information about how to submit claims for reimbursement.
See IRS Publication 503, Child and Dependent Care Expenses, and Form 2441, Child and Dependent Care Expenses, for more details.
Other ways to save on childcare costs
If you don’t already know about these measures, let’s revisit them. The tax law passed in late 2017 affects several of them, so plan accordingly in the coming years.
Exemptions for dependents
Prior to 2018, you could claim your children as dependents on your tax return. Each child claimed sheltered a chunk of money from taxes. For 2017, that amount was $4,050. It did not matter when the year your child was born or adopted. If you were expecting a child shortly, you should have changed your withholding on your W4 form to reflect the new dependent.
This change would also increase your take-home pay. If you were currently single with no children, your first baby could change your tax filing status from single to the head of household. This change would give you a larger standard deduction as well as an exemption for the child.
To be considered the head of household, you must pay more than half the cost of providing a home for this person. If someone else pays that share, you do not qualify.
Beginning in 2018, exemptions are discontinued, so the above discussion does not apply. However, the standard deductions have increased greatly, and there is a new $500 tax credit for other dependents; this tax credit did not exist previously. The child tax credit doubled from $1,000 to $2,000. For some parents, these changes will compensate for the loss of the exemptions; for others, they may not.
The tax law expires beginning in 2026, and unless these changes are made permanent, exemptions may once again be possible.
Earned income tax credit
If you are low-income, the earned income tax credit (EITC) was made just for you. It is a tax credit for certain people who work and have low wages. The amount you can get varies, but it is larger if you have children. The more children you have, the larger the credit. If the credit should exceed the amount of tax you owe, the result is a tax refund that the IRS will send you.
Donate kids’ things
If you’d like to get back some of the money you spent on all those kids’ toys, consider donating them to a qualified charity.
Donations are tax deductible (as long as you itemize your expenses on your tax return as opposed to taking the standard deduction). Given the large increase in the standard deduction, many taxpayers will no longer benefit tax-wise from making donations.
There are other ways that bear mentioning. These investments for children can pay off, though not directly for you:
- Coverdell education savings accounts. You can contribute to a child’s fund for educational expenses, and the balance grows tax-deferred and is not taxed if used for qualified expenses. However, you do not get to take a tax deduction for what you contribute.
- 529 plans. These plans let you put away money for a child’s higher education expenses. While the money grows tax-deferred and is not taxed if used for qualified expenses, you do not get to take a tax deduction for your contributions. The new tax law allows 529 plan account funds to now be used for levels of education other than college, for example, private school and tutoring expenses up through 12th grade.
- Custodial investment accounts. You can set up a custodial account for your child with investments in it, and you can fund the investments. The earnings on the investments are not tax-deferred, nor are you able to deduct what you contribute. Instead, any earnings are taxed at the child’s tax rate, which is likely to be less than yours. Also, the account belongs to the child, and access to the money in it is given to the child at legal age.
Although these investment vehicles do not return tax savings to you now, they may save you money years down the line, depending on how you choose to help your children financially when they are older.
IRS Publication 970, Tax Benefits for Education, describes Coverdell and 529 plans in more detail.
parents can benefit from several tax credits and exemptions to reduce their tax liability while supporting their family. The Child Tax Credit is a refundable tax credit that can eliminate the entire tax burden, and the Childcare Credit provides a tax credit of 20-35% of the first $3,000 in childcare expenses per child per year. Dependent Care Accounts allow parents to set aside money from their earnings for various expenses related to the care of their children, and it is free of federal, state, and Social Security taxes. However, parents need to plan their expenses carefully as they cannot use both the dependent care account and the childcare tax credit for the same expenses. Additionally, the funds that can be used from the dependent care account are limited by earned income, and there is a maximum contribution limit, which if not utilized, can be forfeited.
What is the Child Tax Credit?
The Child Tax Credit is a refundable tax credit that can erase one’s whole tax burden if it exceeds the tax liability.
What is the phaseout for the Child Tax Credit?
The phaseout for the Child Tax Credit begins at $200,000 for single and head-of-household filers, and $400,000 for those who are married and filing jointly.
What is the Additional Child Tax Credit?
The Additional Child Tax Credit is a refundable tax credit for low-income taxpayers that can exceed their tax liability, with a refundable limit of $1,400.
How do I claim the Additional Child Tax Credit?
You must fill out IRS Form 8812 to claim the Additional Child Tax Credit, and your earned income must be at least $2,500.
What is the Childcare Credit?
The Childcare Credit is a tax credit of 20-35% of the first $3,000 in childcare expenses that you pay per child per year.
Who is eligible for the Childcare Credit?
To be eligible for the Childcare Credit, the children must be under age 13 or permanently and totally disabled.
Can I use both a Dependent Care Account and the Childcare Credit for the same expenses?
No, you cannot use both a Dependent Care Account and the Childcare Credit for the same expenses, as that would be considered double dipping.
What is a Dependent Care Account?
A Dependent Care Account also called a childcare reimbursement account, is an account that allows you to set aside money from your earnings for various childcare expenses.
What are the contribution limits for a Dependent Care Account?
The maximum contribution limit for a Dependent Care Account is $5,000 for married couples filing jointly and $2,500 for married couples filing separately.
Can I use funds from my Dependent Care Account beyond the legal limit?
No, you cannot use funds from your Dependent Care Account beyond the legal limit. However, you may be able to take the Childcare Credit for expenses incurred beyond that amount, up to the legal limit.