The American Rescue Plan Act of 2021 (ARPA) makes major, but temporary, changes to the federal income tax child and dependent care credit (CDCC).
Except for when it comes to high-income taxpayers, the changes are all favorable.
To understand the changes, let’s first review the basics. Here goes.
If you have one or more qualifying individuals (usually your children) under your wing, you’re 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, to claim the CDCC, you generally must file a joint Form 1040 for the tax year in question.
But some married-but-separated taxpayers are exempt from the joint-filing requirement.
Qualifying individuals are defined as your under-age-13 child, stepchild, foster child, brother or sister, step-sibling, or descendant of any of these individuals. The child must live in your home for over half the year, and must not provide more than 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.
Eligible expenses include payments to a day-care center, nanny, or nursery school. Costs for overnight camp don’t qualify. K-12 costs don’t qualify either because those are considered education expenses rather than care expenses. But 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 cost goes toward care of a qualifying individual.
Key point. Except for tax year 2021, the CDCC is non-refundable. That means you can use it to offset only your federal income tax liability. If you have no liability, you get no credit.
Eligible expenses cannot exceed the income that you earn--or that your spouse earns, if you’re married--from work, self-employment, and 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.
But 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 either $250 (if you have one qualifying individual) or $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.
Except for tax year 2021, your eligible expenses cannot exceed $3,000 for the care of one qualifying individual or $6,000 for the care of two or more qualifying individuals.
The maximum credit equals 35 percent of eligible expenses if your adjusted gross income (AGI) is $15,000 or less. So, for taxpayers with very modest incomes, the maximum credit is $1,050 ($3,000 x 35 percent) for one qualifying individual or $2,100 ($6,000 x 35 percent) for two or more qualifying individuals.
Except for tax year 2021, your credit rate is reduced by one percentage point for each $2,000 (or fraction thereof) of AGI in excess of $15,000, until the rate bottoms out at 20 percent.
Once your AGI exceeds $43,000, you are in the minimum rate (20 percent) income category. The maximum credit for folks in this income category is therefore $600 ($3,000 x 20 percent) for one qualifying individual or $1,200 ($6,000 x 20 percent) for two or more qualifying individuals.
Taxpayer-Friendly Changes for 2021
For your 2021 tax year only, the ARPA makes the temporary changes summarized below.
Credit Is Potentially Refundable
For 2021, the CDCC is refundable if your main residence is in the U.S. for more than half the year. For joint-filing married couples, either spouse can meet this requirement.
Credit Will Be Much Bigger for Many Families
For 2021, the dollar limits on the amount of eligible expenses for calculating the CDCC are increased to $8,000 if you have one qualifying individual (up from $3,000) or $16,000 if you have two or more qualifying individuals (up from $6,000).
For 2021, the maximum credit rate is increased to 50 percent (up from 35 percent). But the 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 percent if your AGI exceeds $183,000.
For 2021, the maximum CDCC if you have AGI of $125,000 or less is $4,000 for one qualifying individual ($8,000 x 50 percent) or $8,000 for two or more qualifying individuals ($16,000 x 50 percent). Under the “regular” rules for tax years before and after 2021, the maximum credit amounts are only $1,050 and $2,100, respectively.
For 2021 the maximum CDCC if you have AGI of more than $183,000 is $1,600 for one qualifying individual ($8,000 x 20 percent) or $3,200 for two or more qualifying individuals ($16,000 x 20 percent). Under the regular rules for tax years before and after 2021, the maximum credit amounts when the credit rate is reduced to 20 percent are only $600 and $1,200, respectively.
Credit Rate Is Further Reduced or Eliminated for High-Income Taxpayers
For 2021, the credit rate is 20 percent 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. Your 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 percent if your AGI exceeds $438,000.
Flexible Spending Account Deal for 2021
For tax year 2021, the ARPA also increased the maximum amount you can contribute to an employer-sponsored dependent care flexible spending account (FSA) from $5,000 to $10,500. Your contribution reduces your taxable salary for federal income and payroll tax purposes (and usually for state income tax purposes, too, if your state has an income tax). Then you can take tax-free withdrawals to reimburse yourself for eligible dependent care expenses.
If you would like to discuss the CDCC, please contact us at 262-358-8297.
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Spencer Accounting Group, LLC does not provide investment, tax, legal, or retirement advice or recommendations in these blogs. The information presented here is not specific to any individual's personal circumstances.
Keana Spencer is an Accountant, Entrepreneur, and Educator to her clients, with a strong passion. Keana has over 10 years of experience and through her practice, she is a source of knowledge and strategies to her clients.