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    Taxes and paying and daycare; two of the worst things ever are being combined in this post to make them both a little less painful. It might not be fun to talk taxes, but much like paying for daycare, you need to do it.

    Child and Dependent Care Tax Credit and Dependent Care FSA

    There are two great tools to help you save on your taxes because you are paying daycare costs. They both offer assistance on the cost of child care but work in very different ways. Not only are they structurally different, but having a Dependent Care FSA can sometimes prevent you from qualifying for the tax credit.

    In both cases, both spouses must be working. To qualify for the tax credit, both spouses must be earning more than the tax credit.

    Dependent Care FSA

    A dependent care flexible spending account allows you to put aside money to pay for child care cost tax-free. You are entitled to contribute up to $5,000 per year and avoid paying taxes on the contribution.

    Much like a 401k, each paycheck will have a deduction for your FSA contribution. When you pay your childcare bill, you will be able to submit a request for that bill to be reimbursed. The FSA will then reimburse you up to the cost of the bill or the full amount in the FSA but will not give you more money than you put in.

    Dependent and Child Care Tax Credit

    The tax credit is a little more complicated. The tax credit will allow you to use up to $3000 of child care costs for one dependent or $6000 for two or more dependents. If you receive any child care related benefits from your employer, that will lower your maximum credit.

    For example, if you have two children, you can use up $6,000 of qualifying expenses. If you also contribute $5,000 to your dependent care FSA, you can now only use $1,000 of qualifying expenses.

    Once you have figured your maximum benefit, your income will determine what percentage of the benefit will be your credit. The more money you make, the lower your tax credit.

    Making A Decision

    Your Adjusted Gross Income is a critical driver in making the correct decision. Let’s look at how big of an impact this can have.

    Let’s pretend Jack and Jill have two children in daycare. They are spending roughly $1,800 per month ($21,600 a year). We will look at two scenarios, and the only difference will be their income.

    In scenario one, they will have a combined Adjusted Gross Income of $100,000, and in scenario two, they will have a combined income of $50,000.

    Scenario 1

    Contributing $5,000 to the FSA will save them about $1,100 (22% of $5,000)

    The tax credit will save them: $200

    The tax credit is figured this way:

    $6,000 – Maximum allowed expenses

    $5,000 – subtract out the FSA contribution

    $1,000 – dollar limit on qualifying expenses

    $200 – 20% off their qualifying expenses.

    Total benefit = $1,300

    Choosing not to use the FSA would have only allowed them to receive $1,200.

    Scenario 2

    Contributing $5,000 to the FSA saves $600 on taxes ($5,000 at 12%).

    The tax credit will be $200 using the same calculation as above. On a side note, if Jack and Jill’s income were to decrease below $43,000, the tax credit would begin to increase to as much as $350.

    In scenario 2, using the FSA nets them a total of $800 in tax benefit.

    What if they did not use the FSA but only used the tax credit? They would have saved $1,200 (or as much as $2,100 if they made less money).

    Income Is the Deciding Factor

    As your income grows, the FSA becomes a better tool, but it can be very harmful to lower-income families. In Jack and Jill’s example, we are talking about $400 a year. For a family of 4 with $50,000 in income, that is a good chunk of money.

    It is very easy to make large mistakes by not understanding taxes. At Family Life Financial Planning, we work with everyday families to help minimize your tax bill and maximize the benefits given to you.

    For informational purposes only. It is important to consult a professional before implementing any strategies or ideas.