By Matt Elliott, CFP®, CSLP® of Pulse Financial Planning, Guest Writer
Changes to the 2021 tax code have made planning for your child and dependent care tax benefits even more crucial than in previous years. By coordinating your Dependent Care Flex Savings Account (DCFSA) and Child and Dependent Care Tax Credit (CDCTC), you could potentially shave thousands of dollars off your tax bill. Here is what you need to know about changes to these programs in 2021 (and beyond) to optimize your tax bill.
What Is a Dependent Care Flex Savings Account (DCFSA)?
Dependent Care Flex Savings Accounts are special accounts that allow you to set aside money for childcare before taxes are taken out. The account is only available through your employer. If your workplace does not offer a DCFSA, you are unable to take advantage of this benefit (you can skip this section and focus solely on the Child and Dependent Care Tax Credit). If you do have access to a DCFSA though, they come with huge potential tax benefits as well as some key decisions you will need to make to maximize those benefits.
DCFSA Account Benefits
- Offers tax savings when used for eligible child or dependent care expenses.
- Account offered through employer payroll reduction.
- Contribution limit is up from $5,000 to $10,500 for 2021 (but not all plans adopted the higher limit).
- Contribution elections are made during open enrollment.
- May be eligible to make changes mid-year in some cases.
- Unused funds are generally forfeited. Exceptions may be made in 2021, check with your plan provider to verify if they will allow a carryover.
If you have difficulty wrapping your head around these types of accounts, here is one way to think about it: if you let your paycheck flow through regular payroll, you are going to have federal, state, and FICA taxes taken out before the money hits your bank account. Of course, you can then use that after-tax money to buy anything you want. If you know you will be spending your money on childcare anyway, though, why not skip the taxes? With a Dependent Care FSA, you can divert up to $10,500 (2021) without having any taxes siphoned off the top.
DCFSA 2021 Contributions
Contributions to a DCFSA are made with pre-tax dollars through a salary reduction. Typically, these accounts are established through your employer during open enrollment, and you are stuck with your election for the entire year. Rules are more lenient in 2021, though, so contact your employer if you are interested in making a mid-year change to your plan.
The maximum contribution limit to a DCFSA account is $10,500/year ($5,250 if married filing separately) for 2021. However, not all plans adopted the new higher maximum contribution and are sticking with the old $5,000 limit. The contribution limit is scheduled to drop back down to $5,000 in 2022, but there is a fair chance that these new higher limits are made permanent.
Contributions to your DCFSA are exempt from federal, Social Security (FICA), and most state taxes. Depending on your income and state, your tax savings can easily exceed 40%. The higher your tax bracket and higher your state taxes, the more attractive a DCFSA is.
Do not elect to contribute more than what you reasonably expect your qualified childcare costs to be. If you have funds left in your account at the end of the year, they are typically forfeited. However, due to pandemic-related relief that was passed, you may be eligible to carryover any unused balance into 2022. Check with your plan provider before counting on a carryover as some providers may choose to set their own more stringent rules.
DCFSA-Eligible Expenses
Common Dependent Care FSA eligible expenses include:
- Daycare
- Nanny expenses
- After-school or extended-day programs
- Dependent care center
- Au pair
- Expenses paid to relative for dependent care
- Preschool and nursery school
- Summer day camp (if primary purpose is custodial and not education)
These are examples and not intended to be a comprehensive list. Contact your DCFSA provider if you have specific questions about expense eligibility. Care providers may need to meet specific requirements for expenses to be eligible.
Before planning on using a DCFSA, verify:
- That your employer offers a Dependent Care FSA.
- That your employer will allow you to start or change contributions mid-year if you are not already taking advantage of one. If not, make sure to address this during next year’s open enrollment.
- That your specific dependent care expenses qualify to be reimbursed from the account.
Can Both Spouses Contribute to DCFSA?
If you are married, and both spouses have access to a Dependent Care FSA through your employer, which spouse should contribute? If you both earn less than the Social Security wage base ($142,800 in 2021), it really doesn’t matter. However, if one spouse earns more than this, and one earns less, the best strategy is to have the lower-earning spouse contribute to the DCFSA.
The reason is FICA tax is paid per earner (not based on joint income, like most taxes). The higher earner only pays about 2.35% FICA tax on wages above the Social Security wage base, and the lower earner is still paying the full 7.65% in FICA tax on their paycheck. This means that the lower earner stands to save about 5.3% more in taxes than the higher earner by using a Dependent Care FSA. On an annual $10,500 contribution, that could result in $556.50 in tax savings just by having the lower-earning spouse contribute to the account rather than the higher-earning spouse.
Dependent Care Flex Savings Account Case Examples
Example 1:
Sallie is a physician at the local hospital and earns $300,000 per year. Sam is a scientist and earns $75,000 per year. They are married and have 2 children—Sebastian is 4 and Sophia is 1. They live in Minnesota and are in the 32% federal and 9.85% state tax brackets.
Both Sam and Sallie’s employers offer a Dependent Care FSA. Sam and Sallie had $25,000 in eligible childcare expenses last year and expect it to be about the same in 2021. Since Sam is the lower-earning spouse, he elected to contribute the maximum allowed $10,500 for 2021. By paying for childcare through their DCFSA, they can avoid 32% of federal, 9.85% of state, and 7.65% of FICA tax (a total of 49.5%) on $10,500 in eligible expenses. The result is a tax savings of $5,197.50 in 2021 for Sam and Sallie ($10,500 x .495 = $5,197.50).
Example 2:
John is a resident at the local hospital and earns $60,000 per year. Jane is currently in medical school and has no income. They are married and have a 2-year-old child. They live in Minnesota and are in the 12% federal and 5.35% state tax brackets. John’s employer offers a Dependent Care FSA to residents. John and Jane expect about $10,000 in qualified childcare expenses in 2021.
John works with Sam, and heard Sam touting how much money his family saves by utilizing their DCFSA. As a result, John thought he would take advantage of this, as well, and elected to contribute $10,000 for 2021.
By paying for childcare through their DCFSA, John and Jane can avoid 12% of federal, 5.35% of state, and 7.65% of FICA tax (a total of 25%) on $10,000 in expenses. The result is a potential tax savings of $2,500.00 in 2021 ($10,000 x .25 = $2,500.00). To see if this is the best strategy for the family, this number needs to be compared to the tax savings the Child and Dependent Care Tax Credit offers.
Child and Dependent Care Tax Credit (CDCTC)
Fact summary:
- The amount of eligible dependent care expenses has increased in 2021 to $8,000 for one child or $16,000 for two or more children.
- The amount of your tax credit is determined by multiplying your eligible dependent care expenses by your Applicable Percentage.
- Your Applicable Percentage can be anywhere from 0%-50% depending on your Adjusted Gross Income (AGI) (regardless of your filing status).
- Those with an AGI less than $185,000 in 2021 will have an increased potential tax credit available compared to previous years.
- Those with an AGI more than $440,000 in 2021 will not be eligible for the CDCTC, even though they were eligible in past years.
- You cannot claim the Child and Dependent Care Tax Credit for expenses that were covered by your DCFSA. Expenses paid by the DCFSA still count toward your $8,000/$16,000 maximum amount of CDCTC eligible expenses.
Prior to 2021, the Child and Dependent Care Tax Credit was available to help offset some dependent care expenses of up to $3,000 for one child, and $6,000 of expenses for two or more children. This has significantly increased for 2021, allowing for up to $8,000 of expenses for one child, and $16,000 of expenses for two or more children.
Previously, the maximum percentage of eligible expenses (“Applicable Percentage”) you would receive a tax credit for was 35%, although the number ended up actually being 20% for most people (if your AGI was above $45,000, your Applicable Percentage was 20%). This resulted in a modest tax credit for those not taking advantage of a DCFSA. Due to higher potential benefits under both programs in 2021, it is worth revisiting how this tax credit will affect you in 2021.
The maximum Applicable Percentage for 2021 has increased to 50% and has a much higher AGI limit of $125,000 (regardless of your filing status) before your Applicable Percentage gets reduced. The Applicable Percentage phases out 1% for each $2,000 above the $125,000 limit until reaching 20%. So once your AGI is above $185,000, your Applicable Percentage will be 20%. A new phaseout begins again at $400,000, before the tax credit is completely phased out once AGI is above $440,000.
This one can be confusing, so here are some examples:
Your CDCTC will likely be significantly different than in previous years.
Most people with a qualifying dependent can expect a larger tax credit for 2021. The exception is for those with an AGI above $400,000. The phaseout of the credit now resumes at an AGI of $400,000 and is completely gone at an AGI of $440,000 (this was not a provision prior to 2021).
If your AGI was above $440,000, you were eligible for a credit in past years, but no longer in 2021. If the amount of taxes you will owe is different than it has been in the past, you may want to consider adjusting your tax withholding. The IRS has a handy calculator you can use here.
For now, the changes to the CDCTC are temporary provisions for 2021 only. However, many are speculating that at least some, if not all, of the changes may be made permanent.
Child and Dependent Care Tax Credit Case Examples
Example 1:
Sam and Sallie have an AGI of $349,900 in 2021. They had $25,000 in eligible childcare expenses. Sam and Sallie’s Applicable Percentage is 20%.
Their maximum amount of eligible expenses for 2 kids is $16,000 under CDCTC. Remember they already paid for $10,500 of childcare through their DCFSA. This means that only the remaining $5,500 of childcare expenses can be used to qualify for the CDCTC ($16,000 2 child max – $10,500 paid through DCFSA = $5,500). As a result, Sallie and Sam qualify for $1,100 in the Child and Dependent Care Tax Credit ($5,500 x .20).
Example 2:
John and Jane have an AGI of $34,900 in 2021. They had $10,000 in eligible childcare expenses. Sam and Sallie’s Applicable Percentage is 50%.
Their maximum amount of eligible expenses for 1 child is $8,000. As a result, John and Jane would qualify for $4,000 in the Child and Dependent Care Tax Credit ($8,000 x .50 = $4,000). To see if they can claim this credit, we need to examine how their DCFSA contributions affect the potential CDCTC.
Combining Dependent Care Flex Savings Account (DCFSA) and Child and Dependent Care Tax Credit (CDCTC)
Since you cannot claim the CDCTC for expenses reimbursed from your DCFSA, you need to decide which program to prioritize taking advantage of.
You can do this by calculating your Applicable Percentage (explained in the CDCTC section above) and compare it to your estimated total incremental tax burden (described in the DCFSA section above). Whichever calculation ends up with the higher percentage, is the program you should take full advantage of first in most cases.
If the CDCTC is more favorable for you, and you contribute to a DCFSA, you will be forfeiting the higher benefit that you would receive through the CDCTC. This is why planning ahead for which benefit will be more optimal for you is crucial.
The higher your income, the more attractive the DCFSA is, with lower incomes being better off with the CDCTC. This is because lower incomes will qualify for a higher Applicable Percentage in the CDCTC, while higher incomes will be able to avoid a higher tax burden with the DCFSA. In general:
- If your AGI is less than $125,000, the CDCTC is likely going to be the better option.
- If your AGI is more than $185,000, the DCFSA is likely going to be the better option. You may still be able take advantage of some of the CDCTC still depending on your income, amount of your contribution, number of kids, and amount of eligible expenses.
- If your AGI is between $125,000-$185,000, you need to run the numbers to decide which program provides you the most benefit.
- If you have 2 or more children, and max out your DCFSA, you may still claim some of the CDCTC if your eligible expenses were more than $10,500.
- If you have 1 child and eligible childcare expenses of more than $8,000, you need to run the numbers to see which program provides you the higher benefit. Since the DCFSA limit is higher ($10,500 vs $8,000), it may still come out better even if the Applicable Rate is slightly higher than the tax savings that the DCFSA would provide.
Combining DCFSA and CDCTC Case Examples
Example 1:
As discussed above, Sam and Sallie have 2 children and their Applicable Percentage is 20%, while Sam’s total incremental tax is 49.5%. Since the tax rate is higher than the Applicable Percentage, Sam should first max out his contribution ($10,500) to the Dependent Care FSA. Sam and Sallie can still take advantage of the Dependent Care Tax Credit on $5,500 of their remaining eligible expenses.
DCFSA Tax Savings: $5,197.50
CDCTC Tax Savings: $1,100
Sam and Sallie’s total tax savings is $6,297.50 by optimizing benefits from both programs.
Example 2:
As discussed above, John and Jane have 1 child and their Applicable Percentage is 50%, while their total tax savings from a DCFSA is 25%. Since the Applicable Percentage is higher than the tax savings, they should take advantage of the CDCTC. However, they already elected to contribute $10,000 to the DCFSA, which will exclude them from using the CDCTC since they contributed more than the 1 child limit ($8,000).
So instead of a $4,000 tax credit through utilizing the CDCTC, John and Jane are unable to use the CDCTC at all. They instead saved $2,500 in taxes through the DCFSA.
Actual DCFSA Tax Savings: $2,500
Missed CDCTC Tax Savings: $4,000
By using the DCFSA instead of the CDCTC, John and Jane paid $1,500 in extra taxes in 2021.
During open enrollment for 2022, John and Jane will carefully project their income as well as childcare expenses before making the decision of using a DCFSA again next year. In the meantime, they can contact their DCFSA plan administrator to see if it is possible to make changes to their elections mid-year.
Have you used a DCFSA or CDCTC to maximize your tax efficiency? Would this information change how you are doing this? Comment below!
[Editor's Note: Pulse Finacial is a paid advertiser and a WCI Recommended Financial Advisor however, this is not a sponsored post. This article was submitted and approved according to our Guest Post Policy.]
Wow, really enjoyed this thorough explanation and the examples. Thanks!
Thanks for your feedback, glad you found it helpful!
Matt Elliott, CFP®, CSLP®
Thank you for your excellent post!
Do you have information available of how to pay nanny taxes and how to file it in order to get deduction?
I will appreciate your help!
I haven’t written an article on that subject, but there are many out there:
https://www.care.com/c/setting-up-nanny-taxes-payroll
Unfortunately, most of us are quite limited with how much we can contribute as the vast majority of docs are Highly Compensated Employees (HCEs) and most plans cap contributions from HCEs anywhere from $1,500 to $3,000 a year.
Matt,
You are right about that, each plan sets their own contribution limits and may be subject to much lower allowed contributions for HCEs to pass nondiscrimination testing. Something I should have mentioned in the article but I’m glad you brought it up in the comments. For those wondering why your contribution limits are so much lower, this is likely the reason.
Matt Elliott, CFP®, CSLP®
“This means that the lower earner stands to save about 5.3% more in taxes than the higher earner by using a Dependent Care FSA. ”
Would this logic and savings also translate to retirement account options? We are fortunate to have a whole lot of tax protected space (thanks to pensions more than we need to meet our goals) between my physician job and my wife’s public school job (quite lower paying).
Would I be saving more to completely max out my wife’s tax protected space first to maximize these savings in the same way? I.E. prioritize filling her 403b and governmental 457b first in her lower paying job, and then my 401K and lastly my mega-backdoor-Roth via my higher paying job? The 5.3% bump just by doing things in that order seems fairly significant.
David,
This is a great question! Contributions to the types of employer retirement savings plans you mentioned are still subject to FICA taxes, so you wouldn’t get any additional tax benefit from contributing to one spouse’s plan over another.
The exemption from FICA taxes is unique to Flex Savings Accounts which opens up some of the unique tax planning strategies discussed above.
Matt Elliott, CFP®, CSLP®
The employee contribution yes, but not the employer contributions. So if the lower earner were formed as an S Corp, then there could be some savings.
Hopefully you’re maxing them both out each year, in which case there really is no advantage which you do first. But if you’re not maxing them both out, then sure, max out the one that’ll save you a little more SS tax.
Sandeep,
Thanks for your feedback, I’m glad you found it helpful.
Best of luck with your tax planning!
Matt Elliott
I had never heard of DCFSA or its existence, or the fact that some companies actually offer it as a benefit. You learn something new everyday. Bonus points if it’s especially a valuable piece of information like tax savings accounts.
Thank you for this info- this is the most clear explanation of the income phase-out for the credit that I’ve seen so far.
Also good to confirm our strategy for the DCFSA (through my husband’s job- who makes less than the Social Security cap) is a good one
Note that the CDCTC only applies to children under 13, which is notably different than the 2021 changes to the American Recovery Act’s child credit that apply to children under 17. Perhaps this could be included in your CDCTC fact summary for clarification.
This was a really great article. Thank you!
I had a question regarding the federal tax rate used to calculate the DCFSA savings. Is this the effective tax rate? Or would it be 24%? Our AGI was $105,000 last year. Wasn’t quite sure how to calculate that.
Roxanne,
When looking at the federal tax savings, you would use your top incremental tax bracket. If you are in the 24% tax bracket, every dollar you increase your income by is taxed at 24%. You would use that number as a factor to calculate tax savings from reducing your income from strategies such as contributing to a DCFSA. One exception would be if you reduce your income enough to drop down to a lower tax bracket, you would use a weighted average of the 2.
The effective tax rate is an average of your tax liability. Since the US uses a progressive tax system, it is not a good indicator of the savings you would get from reducing your income. Once you “fill up” those lower tax brackets, they aren’t particularly relevant to each incremental dollar you increase or reduce your income by. This is the core of a lot of tax planning strategies such as Roth conversions and the pre-tax vs. Roth contribution question among others.
The US tax code can be tricky, I hope that answers your question.
Matt
How is the DCFSA affected by couples that file-married filing separately? Can we both take 2500 dependent care fsa claim to total 5k for 2022?
Not 100% sure, but deductions like that are usually split when filing separately.
Should be the marginal tax rate, not the effective tax rate.
For a healthcare FSA, does the same apply, where the lower income spouse should make contributions?
This was a great article to find and read prior to the end of the year. One question I had regarding utilizing both the DCFSA and the DCTC: I already contributed $5000 to a dependent care FSA for 2021, but stand to benefit more from the expanded DCTC, and my employer has already stated all FSA funds will be rolled into 2022. I expect to have roughly $9500 in daycare expenses for the year. Is it possible to only reimburse myself for $1500 from the FSA at the end of the year, and claim the remaining $8000 in expenses for the DCTC when filing 2021 taxes? And let the remaining FSA funds roll over into 2022?
My spouse graduated residency this year. Prior to graduating she put $2600 into her residency DC FSA. Her new employer offers one as well but says there is a $2500 limit for “highly compensated individuals “ about 135k+ whether married filing jointly or separately. We file jointly and will likely have a little more than $200k combined income this year.
Can someone confirm that this $2500 limit is an employer restriction and not an IRS restriction? And thus she would be able to maximize the additional $2500 in addition to the previous $2600 ($5100 total) since it is below the new limit of 10,500$ per year?
https://www.shrm.org/resourcesandtools/hr-topics/benefits/pages/american-rescue-plan-act-raises-dependent-care-fsa-limits-and-adjusts-tax-credits.aspx#:~:text=It%20also%20increases%20the%20value,care%20tax%20credit%20for%202021.&text=The%20new%20DC%2DFSA%20annual,for%20married%20individuals%20filing%20separately.
The new DC-FSA annual limits for pretax contributions increases to $10,500 (up from $5,000) for single taxpayers and married couples filing jointly, and to $5,250 (up from $2,500) for married individuals filing separately. The higher limits apply to the plan year beginning after Dec. 31, 2020 and before Jan. 1, 2022.
Many employers impose lower contribution limits than the IRS limit for highly compensated employees. Employers have to pass means testing for the plan to remain qualified. If mostly HCEs are taking advantage of the benefit, your employer may be forced to have a lower contribution limit to keep the plan in place.
As a household you are held to the IRS limit, not the employer limit. So you can contribute to multiple DCFSA plans if you have access to more than 1 as long as your family remains below the $10,500 2021 limit. If you have any questions, let me know and I’d be happy to help.
Matt
Can you speak to the new phaseouts for 2023 (2022) filing year? If income is 330k (after tax deductions – including standard deduction) with 3 kids, what would you expect for phaseout number for dependent care tax credit and child tax credit? What is the phaseout for dependent care tax credit? I cant find it with the new change for this year. Thanks for all that you do!
I don’t know them exactly, but given inflation for the year was about 7%, I’d expect any phaseouts indexed to inflation to increase by about that much.