The American Rescue Plan Act includes major, but temporary, changes to the longstanding federal income tax child and dependent care credit.
The changes are favorable for most taxpayers, except high-income individuals. Here's what you need to know about this credit and how it's changing for 2021.
If you paid expenses for the care of one or more qualifying individuals, you may be eligible for the child and dependent care credit. The credit covers eligible expenses that you pay 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 child and dependent care credit. However, some married but separated taxpayers are exempt from the joint-filing requirement.
A qualifying individual is defined as your under-age-13:
- Foster child,
- Brother or sister,
- Stepsibling, or
- A descendant of any of these individuals.
The individual 1) must live in your home for over half the year, and 2) 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 a sleep-away camp don't qualify. Costs for kindergarten and above don't qualify, because they're considered education expenses rather than care expenses. However, costs for before- and after-school programs can qualify. Costs of domestic help can also qualify, if at least part of the costs go toward the care of a qualifying individual.
Important: Before the ARPA, which was signed into law on March 11, the child and dependent care credit was nonrefundable. That means it could only be used to offset your federal income tax liability. If you had no liability, you got no credit.
Before and after the ARPA, eligible expenses can't exceed the income that you earn, or 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 can't claim the child and dependent care credit. However, if your spouse has no earned income and is a full-time student or disabled, he or she is deemed to have monthly earnings of $250 if you have one qualifying individual or monthly earnings of $500 if you have two or more qualifying individuals. Under this exception, you can potentially claim the child and dependent care credit even though your spouse doesn't actually work and has no actual earnings.
Before the ARPA, eligible expenses (after the preceding limitation) couldn't 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 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 modest incomes, the maximum credit was $1,050 ($3,000 × 35%) for one qualifying individual or $2,100 ($6,000 × 35%) for two or more.
The credit rate was reduced by one percentage point for each $2,000 (or fraction thereof) of AGI above $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 people in this income category was $600 ($3,000 × 35%) for one qualifying individual or $1,200 ($6,000 × 20%) for two or more.
Important: These pre-ARPA limitation rules will kick back in for 2022 and beyond.
ARPA Changes for 2021
The ARPA makes the following temporary changes to the child and dependent care credit:
The credit is potentially refundable: For 2021 only, it's refundable for taxpayers who have a principal place of abode in the United States for more than one-half the year. In the case of a married couple that files a joint return, either spouse can meet this requirement.
The credit has been expanded for most taxpayers: For 2021 only, the limits on the amount of eligible expenses taken into account in calculating the credit 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).
The maximum credit rate for 2021 is increased to 50% (up from 35%). But this rate is reduced by one percentage point for each $2,000 (or fraction thereof) of AGI above $125,000. So, the credit 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 credit rate was reduced to 20% if your AGI exceeded $43,000.
So, for 2021 the maximum child and dependent care credit for a taxpayer with AGI of $125,000 or less is $4,000 for one qualifying individual ($8,000 × 50%) and $8,000 for two or more qualifying individuals ($16,000 × 50%). Before the ARPA, the maximum credit amounts were only $1,050 and $2,100, respectively.
For 2021 the maximum child and dependent care credit for a taxpayer with AGI of more than $183,000 is $1,600 for one qualifying individual ($8,000 × 20%) and $3,200 for two or more qualifying individuals ($16,000 × 20%). Before the ARPA, the maximum credit amounts when the credit rate was reduced to 20% were only $600 and $1,200, respectively.
Here's an example to show how these calculations work: For 2021, Jorge, an unmarried individual, earns $132,000 of AGI and pays $8,400 of eligible expenses for care of his two qualifying children so he can work. What's his child and dependent care credit for 2021?
Jorge can take the entire $8,400 into account in calculating his child and dependent care credit. However, his credit rate is reduced from 50% to 46%, because his AGI exceeds the applicable limit by $7,000 ($132,000 – $125,000). Specifically, the four-percentage-point reduction is because Jorge has three x $2,000 of excess AGI plus one fraction of $2,000 of excess AGI. So, his allowable child and dependent care credit is $3,864 ($8,400 × 46%).
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 kicks in.
The credit rate is reduced by one percentage point for each $2,000 (or fraction thereof) of AGI above $400,000. So, the credit rate is reduced to 0% if your AGI exceeds $438,000.
Continuing with the previous example, let's suppose that Jorge earns $420,000 of AGI, instead of $132,000. Assuming everything else stays the same, his credit percentage is reduced from 20% to 10% due to his $20,000 of excess AGI ($420,000 – $400,000). Specifically, the 10-percentage-point reduction is because Jorge has 10 × $2,000 of excess AGI. So, his allowable child and dependent care credit is only $840 ($8,400 × 10%).
Child and Dependent Care Credit vs. Dependent Care FSA
For 2021, the new American Rescue Plan Act increased the maximum amount that you can contribute to an employer-sponsored dependent care flexible spending account from $5,000 to $10,500. A contribution reduces your taxable salary for federal income and payroll tax purposes (and usually for state income tax purposes, 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 child and dependent care credit 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 child and dependent care credit for "excess" eligible expenses under the child and dependent care credit rules, subject to the applicable child and dependent care credit limit on eligible expenses.
Are you better off forgetting about the FSA option and just claiming the child and dependent care credit? It depends on your income and other factors. We can help identify the best tax-saving strategy for your circumstances.
For More Information
At first glance, the ARPA changes to the child and dependent care credit rules for your 2021 tax year might seem simple. But there are a lot of details that factor into the calculation. We can explain the benefits in your situation – contact us for a personalized assessment.