The $1.9-trillion stimulus package known as the American Rescue Plan Act (ARPA) includes major changes to the longstanding federal-income-tax child and dependent care credit (CDCC).
Unless you are in the high-income category, the changes are favorable.
There’s a catch: the changes are temporary.
Here’s what you need to know, after first covering some necessary background information.
Child and dependent care credit (CDCC) basics
Taxpayers with one or more qualifying individuals under their wings are eligible for the CDCC. The credit covers eligible expenses that you pay to care for one or more qualifying individuals so you can work, or if you’re married, so both you and your spouse can work. If you’re married, you generally must file a joint Form 1040 for the tax year in question to claim the CDCC. However, some married but separated taxpayers are exempted from the joint-filing requirement.
Qualifying individuals are defined as your under-age-13 child, stepchild, foster child, brother or sister, step-sibling, or a descendant of any of these individuals. The individual must live in your home for over half the year, and must not provide over half of his or her own support. A handicapped spouse or handicapped dependent who lives with you for over half the year can also be a qualifying individual.
Typical eligible expenses are payments to a day-care center, nanny, or nursery school. Costs for overnight camps don’t qualify. Costs for private K-12 school don’t qualify, because those are considered education expenses rather than care expenses. However, costs for before-school and after-school programs can qualify. Costs of domestic help can also qualify, as long as at least part of the costs go toward the care of a qualifying individual.
Key point: Before the ARPA, the CDCC was nonrefundable, meaning it could only be used to offset your federal income tax liability. If you had no liability, you got no credit. But for 2021, the credit is refundable for most folks, as explained later.
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Before and after the ARPA changes, eligible expenses cannot exceed the income that you earn, or that your spouse earns if you’re married, from work, self-employment, or certain disability and retirement benefits. If you’re married, you generally must use the income earned by the lower-earning spouse for this limitation.
So, under the general limitation rule, if one spouse has no earned income, you cannot claim the CDCC. However, if your spouse has no earned income and is a full-time student or disabled, he or she is deemed to have imaginary monthly earnings of $250 if you have one qualifying individual or imaginary monthly earnings of $500 if you have two or more qualifying individuals. Under this exception, you can potentially claim the CDCC even though your spouse does not actually work and has no actual earnings.
Before the ARPA, eligible expenses (after the preceding limitation) could not exceed $3,000 for the care of one qualifying individual or $6,000 for the care of two or more qualifying individuals.
Before the ARPA, the maximum credit equaled 35% of eligible expenses if the taxpayer’s adjusted gross income (AGI) for the year was $15,000 or less. So, for taxpayers with very modest incomes, the maximum credit was $1,050 ($3,000 x 35%) for one qualifying individual or $2,100 ($6,000 x 35%) for two or more.
Before the ARPA, the credit rate was reduced by one percentage point for each $2,000 (or fraction thereof) of AGI in excess of $15,000 until the rate bottomed out at 20%. So, the credit rate was reduced to the minimum 20% if your AGI exceeded $43,000. The maximum credit for folks in this income category was $600 ($3,000 x 35%) for one qualifying individual or $1,200 ($6,000 x 20%) for two or more.
Temporary taxpayer-friendly changes
For the 2021 tax year only, the ARPA makes the following temporary changes.
Credit is potentially refundable
For 2021, the CDCC is refundable for taxpayers who have a principal place of abode in the U.S. for more than one-half the year. In the case of a joint-filing married couple, either spouse can meet this requirement.
Credit can be much bigger for most taxpayers
For 2021, the dollar limits on eligible expenses for claiming the CDCC are increased to $8,000 if you have one qualifying individual (up from $3,000) and $16,000 if you have two or more (up from $6,000).
For 2021, the maximum credit rate is increased to 50% (up from 35%).
But the 2021 credit rate is reduced by one percentage point for each $2,000 (or fraction thereof) of AGI in excess of $125,000. So, the rate is reduced to 20% if your AGI exceeds $183,000. Before the ARPA, the AGI threshold for the credit rate reduction rule was only $15,000, and the rate was reduced to 20% if your AGI exceeded $43,000.
For 2021 the maximum CDCC for a taxpayer with AGI of $125,000 or less is $4,000 for one qualifying individual ($8,000 x 50%) and $8,000 for two or more qualifying individuals ($16,000 x 50%). Before the ARPA, the maximum credit amounts were only $1,050 and $2,100, respectively.
For 2021 the maximum CDCC for a taxpayer with AGI of more than $183,000 is $1,600 for one qualifying individual ($8,000 x 20%) and $3,200 for two or more qualifying individuals ($16,000 x 20%). Before the ARPA, the maximum credit amounts when the credit rate was reduced to 20% were only $600 and $1,200, respectively.
So far, so good.
Example 1: You are unmarried. In 2021, you pay $15,000 of eligible expenses, for care of your two qualifying children, so you can work. You can count the entire $15,000 to calculate your CDCC. Say your 2021 AGI is $132,000. Your credit rate is reduced from 50% to 46% due to having $7,000 of excess AGI. Specifically, the four-percentage-point rate reduction is because you have three x $2,000 of excess AGI plus one fraction of $2,000 of excess AGI. So, your allowable CDCC is $6,900 ($15,000 x 46%). That helps.
Credit rate is further reduced or eliminated for high-income taxpayers
For 2021, the 20% credit rate applies if your AGI is between $183,001 and $400,000. But once your AGI exceeds $400,000, a second credit rate reduction rule kicks in. The credit rate is reduced by one percentage point for each $2,000 (or fraction thereof) of AGI in excess of $400,000. So, the rate is reduced to 0% if your AGI exceeds $438,000.
Example 2: Same as Example 1, except this time your 2021 AGI is $420,000. You credit rate is reduced from 20% to 10% due to your $20,000 of excess AGI. Specifically, the ten-percentage-point reduction is because you have 10 x $2,000 of excess AGI. So, your allowable CDCC is $1,500 ($15,000 x 10%). Better than nothing.
Example 3: Now let’s say your AGI is $438,500. Your credit rate is reduced by from 20% to 0% due to your $38,500 of excess AGI. Specifically, the 20-percentage-point reduction is because you have 19 x $2,000 of excess AGI plus one fraction of $2,000 of excess AGI. So, the CDCC is completely phased out due to your high income. Sorry.
Liberalized CDCC vs. liberalized dependent care flexible spending account (FSA)
For 2021, the ARPA also increases the maximum amount that you can contribute to an employer-sponsored dependent care flexible spending account (FSA) from $5,000 to $10,500. The contribution reduces your taxable salary for federal income and payroll tax purposes (and usually for state income tax purposes too, if applicable). Then you can take tax-free withdrawals to reimburse yourself for eligible dependent care expenses.
Depending on your specific circumstances, you can have dependent care expenses that are eligible for both the CDCC and for tax-free dependent care FSA withdrawals. If you fall into this scenario, you could contribute some amount to a dependent care FSA, collect the resulting income and payroll tax savings, and take tax-free withdrawals to reimburse yourself for eligible expenses.
You could then claim the CDCC for “excess” eligible expenses under the CDCC rules, subject to the applicable CDCC limit on eligible expenses. To calculate your allowable CDCC, fill out IRS Form 2441 (Child and Dependent Care Expenses) and include it with your Form 1040. The allowable credit amount will show up on page 2 of Form 1040.
Are you better off forgetting about the FSA option and just claiming the CDCC? It depends on your income and other factors. Talk to your tax pro.
The bottom line
The changes to the CDCC rules for the 2021 tax year are not simple. A related issue is how to best take advantage of both the CDCC and the dependent care flexible spending account (FSA) option if your employer offers the FSA deal. That adds another layer of complexity. Finally, be aware that you may be able to claim the child tax credit for 2021 in addition to taking advantage of the CDCC and the FSA deal. That’s some stimulus, folks.