I remember going to Capitol Hill as part of an entrepreneurship day several years ago. I told my business startup story to lawmakers, including the part about paying $2,100 per month in day care expenses for three children and really questioning the financial sense of starting a business. Every time people asked me what entrepreneurs needed, I was a broken record: CHILD CARE.
The American Rescue Plan Act of 2021 is grabbing headlines as real money (that can be used) flows into people's checking accounts, but the parents of young children need to pay particular attention to two child care improvements for 2021 -- the Child and Dependent Care Credit and the dependent care flexible spending account (FSA).
The good news is that a lot more people are going to get a lot more of a tax break for 2021 on their child care expenses. Feel free to stop reading here and start daydreaming of what you will do with all those Benjamins at tax time next year. Or, for those willing to nerd out a little (under the supervision of their CPA), there might be some choices to make to optimize how you use the credit and/or flexible spending account.
Here are the details.
The American Rescue Plan Act expands the Child and Dependent Care Credit and increases the limit for the dependent care flexible spending account for 2021 only.
First, the Child and Dependent Care Credit, or "care credit." The previous maximum applicable percentage used to calculate that credit had been equal to 35% of qualified child care expenses per qualifying child up to $3,000, or $6,000 for two or more kids. Importantly, there was a pretty low phaseout of a 1% reduction for every $2,000 of adjusted gross income (AGI) over $15,000 until it stopped at 20%.
In the new law for 2021, the credit goes from 35% to 50% of qualified expenses with a phaseout starting at a much higher $125,000 AGI, up from the previous $15,000 AGI limit, reduced by 1% for every $2,000 over $125,000 AGI. The credit won't go lower than 20% until $400,000 AGI is reached, at which point the credit starts phasing out to zero. Importantly, you can use up to $8,000 in qualified child care expenses for one kid and up to $16,000 for two or more kids, substantial increases from 2020 limits. To qualify, both spouses have to work full time, and the kids have to be under 13.
The highest credit available for 2021 would be $4,000 for one kid and $8,000 for multiple kids. Oh, and unlike in past years, this is a refundable credit.
Then there's the dependent care FSA. The employer-sponsored dependent care FSA contribution limit is more than doubling in 2021 from $5,000 to $10,500 for single taxpayers and married couples filing jointly. Parents with two kids in full-time child care could easily maximize that ceiling.
Those are the rules. Here's how to play.
First, you have to make a choice: the flexible spending account or the tax credit? Or the FSA and then credit? Or a tax credit and then FSA? That is the question, or those are the questions, or let's just go take a nap and deal with this later.
No, let's persevere.
It seems to me that the winners in the American Rescue Plan Act child care provisions are those making up to $125,000 in adjusted gross income, or even a bit over it. That 50% care credit is amazing -- so amazing that some people might want to ask their CPA if it makes sense to reconsider their FSA election made in the fall, before the law was passed, in favor of using the care credit at tax time. Why? Well, an FSA simply allows you to spend pre-tax dollars on child care expenses. At an AGI of $125,000 or less, even dodging federal, state and FICA taxes, it's hard to beat the 50% care credit. If it makes sense to change your FSA contribution, then you might want to try and do that sooner than later.
For many high-income earners, the dependent care FSA could be particularly advantageous. Let's take a couple who both work full time and make $250,000 AGI. Between summer camp, day care and after-school care, they calculate child care to be about $23,000. The wife's employer has a dependent care FSA available, and the CPA is finding that the FSA has more value than the tax credit. The ideal plan would be to increase the wife's FSA contribution to the maximum $10,500. The remaining child care costs paid out of pocket could then be eligible for the 20% care credit.
Seems simple, but it's not. I have been calling around to human resource departments. Remember, this law just passed on March 11. Human-resources folks are still struggling with the day-to-day issues of health insurance and, oh yes, the global pandemic. I am not sure how easy in practice it could be to increase or decrease an FSA contribution, but it is worth asking the question. Also, don't be surprised if your business opts not to allow employees to increase the FSA beyond the 2020 limits. They might be concerned about the discrimination testing they have to do to keep higher earners from taking on too much of the benefit.
Second, if you are going for the care credit, what more can you do to maximize it? Consider increasing your pre-tax contributions to your retirement plan. So many people could be in reach of the $125,000 AGI limit for the maximum 50% credit if they could think about trying to more aggressively save into their company's pre-tax 401(k), 403(b) or 457(b) to lower their AGI.
Obviously, long after that credit is applied, my hope would be that folks would find they can live just fine with that higher retirement contribution. More likely, they might just forget they were saving so much until it's too late. They start getting close to retirement and to their chagrin find out they have enough money to actually retire. Wouldn't that money have been so much better spent on their youth? Oh well, guess we will have to take some bigger vacations and spoil the grandkids a little more with all that extra money.
I digress. Let's take a couple saving 10% in their retirement account but just over the $125,000 AGI limit to get the maximum 50% care credit. What if they bump up their pre-tax retirement savings contribution rate more (maybe to 14%-15%) to get their AGI in range to qualify for the full credit? What a win-win. They see their retirement savings bolstered, and they get more money back for what they spent on child care.
Third, learn about what is eligible for the care credit. I had mistakenly thought it only applied to formal day care or child care centers. My husband and I will be applying this credit to our summer day camps, which qualify, and we are saving all our online confirmations and printing them for the 2021 tax file. In addition, we have a nanny working with us over the summer and can count what we pay her.
The biggest takeaway is to call your CPA if you think this applies to you. Maria Bean, CPA, of Landmark CPAs confirmed this point. "Now, more than ever, it is critical to collaborate with your CPA regarding how best to utilize some of these (under current legislation) short-lived tax benefits to help best make the tax code work for you," Bean said.
For 2021, pausing in May to get the child care strategy for summer and the rest of the year makes financial sense. The American Rescue Plan has a lot of flashy stimulus payments like the cool kids, but don't overlook the revenge of the tax nerds getting their money's worth out of the dependent care FSA and/or Child and Dependent Care Credit increases.
Sarah Catherine Gutierrez is founder, partner and CEO of Aptus Financial in Little Rock. She is also author of the book "But First, Save 10: The One Simple Money Move That Will Change Your Life," published by Et Alia Press. Contact her at sc@aptusfinancial.com.