Day care can be a real drain on a family budget. SmartMoney.com in 2011 said the average day care charges $4,000 to $6,000 a year for a 4-year-old child. – and that’s for just one child. Fortunately, the Internal Revenue Service allows working parents to pay some child care expenses with pretax dollars. That can add up to a big savings, and it’s not the only day care tax break available.
Dependent Care Accounts
A dependent care account is a type of flexible spending account you can set up through your employer. You put pretax money into the account and use it to pay for child care. The annual limit is $5,000 or the amount of eligible child care expenses, whichever is less. The contributions to a dependent care account are exempt from federal income tax, Social Security tax and Medicare tax.
The amount of money you save with pretax day care depends on which tax bracket you are in. Suppose the highest tax rate that applies to your salary is 25 percent. Add 7.65 percent for the combined Social Security and Medicare taxes. Multiply 32.65 percent by the amount of pretax contributions you make to the dependent care account. If you contribute the full $5,000, the tax savings come to $1,632.50. If your state exempts state income taxes as well, your savings will be more.
If you’re a single parent, the money in your account must be used to pay for child care so you can work or attend school. For married couples, both must work or attend school. Children must be less than age 13 or disabled. Pretax care dollars may be used to care for a disabled adult dependent as well. Don't contribute more to your account than you estimate you will need to spend on day care during the year. At the end of the year or if you leave your job, unused money in the account is forfeited, meaning it reverts to your employer.
You might be able to claim a tax credit for a portion of day care expenses not covered by pretax money. The child and dependent care tax credit has the same eligibility rules as a dependent care account. You can get the tax credit for 20 to 35 percent of dependent care expenses up to $3,000 for one child or $6,000 for two or more children. You have to subtract pretax money from these limits, however. Suppose your dependent care account contributions cover the maximum $5,000 and you have two eligible kids. Subtract this from the $6,000 tax credit limit, leaving $1,000. Your tax credit in this example is $200 to $350, depending on your adjusted gross income.
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