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The Best Way to Get a Tax Break for Child Care Costs

A flexible spending account escapes federal income taxes as well as payroll taxes.

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My employer is offering a dependent-care flexible spending account during open enrollment for 2016, and I’m wondering if it’s better to sign up for this FSA or to take the child-care tax credit. Or can I do both?

See Also: The Most-Overlooked Tax Breaks

If you have the choice, you’ll generally come out ahead with the dependent-care FSA rather than the child-care tax credit. But you may be able to use both if your child-care expenses top $5,000.

The dependent-care FSA lets you set aside up to $5,000 in pretax money for child-care expenses, including the cost of a nanny, day care, a babysitter, preschool, before- or after-school programs, and even summer day camp, for children younger than 13 while you and your spouse work (one spouse can be a full-time student). The FSA escapes federal income taxes as well as the 7.65% in Social Security and Medicare taxes. The higher your income (and higher your tax bracket), the bigger the benefit you’ll get. If you’re in the 25% federal tax bracket, for example, you’ll save 32.65% in taxes on the money you contribute to the FSA, and setting aside $5,000 in the dependent-care account can reduce your tax liability by $1,632.50. You’ll save even more if your contributions reduce your state income taxes, too.

The dependent-care credit, on the other hand, counts up to $3,000 in child-care expenses if you have one child or $6,000 if you have two or more children. The credit is worth from 20% to 35% of those expenses, depending on the size of your income. If your income is more than $43,000, for example, the credit is worth 20% of your eligible expenses. (It’s worth more for lower incomes.) Because it’s a tax credit, it lowers your tax liability dollar for dollar, so if you have $5,000 in child-care expenses for two or more children, your credit would be worth $1,000.

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You can’t double dip tax breaks and use the same money for both the dependent-care FSA and the tax credit. However, if you have two or more kids and sock $5,000 in an FSA, you can count up to $1,000 in child-care expenses toward the dependent-care credit, too. If your income is $43,000 or higher, claiming $1,000 of the credit will be worth $200, even if you’ve maxed out the dependent-care FSA.

For more information, see IRS Publication 503, Child and Dependent Care Expenses.

See Also: The Most-Overlooked Tax Breaks for New Parents

Got a question? Ask Kim at askkim@kiplinger.com.