Kids can be expensive. Anyone who has raised or is raising kids knows this. However, I am a firm believer that kids are as expensive as you make them. With the exception of maybe medical expenses, a lot of what you spend on your kids is in your control. There are a million articles out there that try to come up with an exact figure of what a child will cost parents over a certain amount of time. I try to steer clear of reading those articles mainly because they’re misleading. There are just too many variables that go into the cost of raising a child. One of the biggest variables is childcare.
Childcare expenses can vary widely from family to family. Some families could be lucky enough to not have to pay for childcare. Some may only need it a couple days a week. And families with 2 full time working parents could need it five or more days a week. Whatever the case may be, when families go to calculate the cost of childcare, more often than not they don’t factor in the tax deductions you can get for childcare expenses.
I recently had a client (we’ll call him Bob) ask me if he should take advantage of a dependent care FSA that is offered at his work and how that will effect the credit for childcare expenses that he takes on his tax return. I knew they answer right away because my wife and I were faced with the same decision when we had our first child last year. Let’s take a look at Bob’s figures and see what works best.
The dependent care FSA works like a medical FSA only instead of using it for medical expenses, you use it for child care expenses. You select an amount up to a certain limit to be deducted from your paycheck pre-tax and that gets deposited into an account to be used for childcare expenses. Bob’s employer allows him to contribute up to $2,500 annually to the account. My client was wondering how this would effect the child care credit they can take on their tax return.
Bob is expected to spend about $5,000 a year on child care for one child. He is married filling jointly and their adjusted gross income is about $115,000. If he were to forgo the deduction at work they would have the option to use all of their expenses towards the child care credit on their tax return. However, that credit has limits. The credit is calculated on up to $3,000 in expenses for one child and couples making 43k and up only get to use 20% of that $3,000. So Bob would get a credit of $600 (3,000 X 20%) on $5,000 worth of child care expenses.
Now let’s see what happens when Bob takes advantage of the Dependent Care FSA at work. Bob can choose to max out his Dependent Care FSA because he knows he will be spending more than the $2,500. The amount spent above that $2,500 can be used to take the child care credit on the tax return. So in this scenario, Bob’s $5,000 in child care expenses will result in a $2,500 reduction in federal taxable wages as well as $2,500 to be used to calculate the child care credit on his tax return. Bob is in the 25% tax bracket so the salary reduction will result in a tax savings of $625 (2,500 x .25) and the child care credit will be $500 (2,500 x .2) for a total tax benefit of $1,125. So taking advantage of the Dependent Care FSA resulted in an additional $525 in tax savings.
It would have cost Bob $525 if he just assumed he didn’t need the Dependent Care FSA at work because of the credit he gets on his tax return. $525 a year might not sound like a whole lot but let’s say Bob starts to invest $525 a year in a 529 Plan for that child. In 15 years when Bob’s 3 year old is now 18, he or she could easily have their first semester or even the first year of college paid for.
It’s important to weigh all your options even if you assume you know whats going on. It never hurts to talk about all your options and see what actually benefits you the most.