by Stephen Smith
on January 23, 2017
Congress provides taxpayers a couple of ways to save on day-care expenses for their children, the Dependent Care Assistance Program (DCAP) and Dependent Care Tax Credit (DCTC). Usually more tax breaks are a good thing, but utilizing one of these tax breaks can limit or prevent the use of the other, so it is crucial to understand how these programs work, their similarities, and their differences to determine which one will provide the greatest benefit.
Requirements for both DCAP and DCTC
In order to benefit from either the DCAP or DCTC, you must meet the following requirements:
- Both the taxpayer and the spouse must be gainfully employed when expenses are incurred for the expense to qualify. Looking for work, being a full-time student or being incapable of self-care are considered gainfully employed. If you are unsure whether you or your spouse meet the IRS definition of a full-time student or incapable of self-care, please contact your tax advisor or view our DCAP quick guide.
- Generally the taxpayer and spouse can only claim expenses during the year for the lesser of (1) the taxpayer’s earned income, (2) the spouse’s earned income or; (3) the dependent care expenses incurred during the year. With annual day-care cost usually exceeding $6,000, this normally means to claim the full amount for DCAP or DCTC, both the taxpayer and spouse must individually make at least $6,000. Spouses that are full-time students or disabled are considered to have either $250 or $500 in income for each month they are a student or incapable of self-care, depending on if they have one qualifying individual or 2 qualifying individuals.
- The care must be for certain expenses that qualified for reimbursement. Qualified expenses include before- or -after-school programs, day-care and day camps that are primarily for care and not to learn a skill. The one exception to the primarily-for-care rule is pre-school, which is consider primarily for care even if education is the actual primary reason for pre-school. Ineligible expenses include any school for kindergarten and above, care that is for non-gainful employment reasons (e.g., a babysitter to go out to dinner) or the cost of overnight camp.
- Generally the individual receiving must be the taxpayer’s child and be under 13 when the expense was incurred. If the child’s parents are divorce or separated, only the custodial parent can claim the child. Individuals that use the “Married Filing Separately” status on their income tax return have complex rules and limitations related to Dependent Care expenses and should consult their tax advisor.
What is a Dependent Care Assistance Program?
Employees elect to have up to $5,000 excluded from their gross income by their employer during the year, which means that the funds are not subject to federal income tax, Social Security and Medicare tax, and usually not subject to state income taxes. Many employers run their DCAP through a cafeteria plan, which means that the employee cannot make changes to their election unless there is a qualifying event.
What is the Dependent Care Tax Credit?
This tax credit is claimed on the federal income tax return. Taxpayer receives a 20%-35% tax credit for up to $3,000 in expenses for one qualifying person and $6,000 in expenses for two or more qualifying persons. Because credits are claimed near the bottom of tax returns, the funds used to claim the credit are subject to federal income tax, Social Security and Medicare tax and are generally subject to state income tax, but the credit can reduce or eliminate these taxes.
How to Compare the Benefits
Because there are so many variables to determine what benefit is best for an individual taxpayer, below are some broad rules for when the DCAP will be better than DCTC:
- Higher Adjusted Gross Income (AGI): Generally speaking, the higher your AGI, the more likely DCAP is better for your situation. Your AGI can be found on line 21 or line 37 of your income tax return. Either way, it will be on the last line of the first page of your return.
- Only have 1 Qualifying individual: If you only have 1 qualifying individual, DCAP higher maximum of $5,000 vs $3,000 is more likely to work in your favor.
- State Income Tax: If your state has income tax, DCAP will normally reduce your state income tax liability while DCTC normally will not.
- Higher Margin Tax Rate: Higher marginal rates reap a great benefit for DCAP while DCTC is only based on AGI.
The Best of Both Worlds
In many situations, it is possible to claims both the DCTC and DCAP. Below is an example of how that would work.
Employee Z is single and has 2 children in day-care and the annual cost exceeds $6,000. Z meets all the requirements and both of the children are qualifying individuals. Z determines that DCAP will be a better value for her, so she elects to exclude $5,000 through her employer’s DCAP program. Because Z has two qualifying individuals, she can claim the difference of the DCTC maximum for two qualifying individuals and the DCAP maximum on her taxes, which means Z can exclude $5,000 through DCAP and claim $1,000 in expenses on her tax return for the DCTC.
Both of these benefits can provide tax relief for families that need day-care to allow them to work. With tax season just around the corner, now is a great time to determine which benefit works for you or to discover that you can utilize both to have Uncle Sam help to cover your day-care bill.