Dependent Care FSA vs. the Tax Credit: Which is Better?

We all know that having children can cost a grip.  Luckily, you have a few money saving options to choose from: The Dependent Care FSA and the Child and Dependent Care Tax Credit.

One offers you the opportunity to save loads of cash tax-free to use for your child care expenses.  While the other reduces your tax bill and gives you a bigger tax refund because of those expenses.

Both are great options.  But, sadly, most people can't do both.  

So when it comes to choosing a way to save for your children's expenses, it can be hard to decide which is the better route: The Dependent Care FSA or The Child and Dependent Care Tax Credit?

Well, it's time to breakdown the pros and cons of each of these savings opportunities and see which one works best for you and your family.

What is a Dependent Care FSA?

The Dependent Care Federal Savings Account (FSA) is an account where you can put aside tax-free dollars that you can later use on expenses for your dependent. 

This savings account is great for families who know how much they are going to spend on child care (or other dependent) costs for the year.  Your dependent does not have to be a child but could also be a spouse or relative who lives with you and whom you take care of.

The catch to this tax-free money is all the money you put into your Dependent Care FSA must be used within the year.  Otherwise, you lose it.

How Does the Dependent Care FSA Work?

You can only enroll in the Dependent Care FSA during open season which is usually from mid-November to mid-December.  For 2021, it is from November 9th - December 14th.

During that time, eligible employees may enroll in the Dependent Care FSA online through the FSAFEDS website.  Your enrollment is only good for a year so you must re-enroll each you if you wish to continue.

Once enrolled, money is taken from your check each month and put into your FSA.

Money saved in your Dependent Care FSA can be used for adult day care, before and after school programs, babysitting, summer day camp, and nanny services.

For a complete list on what's covered and what's not covered, check out the table below. 

Things to Note: 

• You can only enroll if your employer offers the Dependent Care FSA.
• If you don't use it, you lose it.  What you put into the FSA must be used within the year or it's gone.
• Only the parent with custody may use this FSA if you are divorced.

Eligible Dependents

So who exactly qualifies as a dependent?  Let's check that out below.

Contribution Limits

There are limits to how much tax-free dollars you can save in your Dependent Care FSA.  Typically, you can save up to $5,000 in pre-tax income for singles and married couples filing jointly.  And $2,500 for married couples filing separately.

However, for 2021, the American Rescue Plan Act (ARPA) substantially increased the amount of money you can save in your Dependent Care FSA account.  

The new contribution limit is $10,500 for singles and married couples filing jointly.  And $5,250 for married couples filing separately.

The jury is still out on whether this increase will be extended to 2022 as well.

Extension of Benefits Due to the Pandemic

Typically, with an FSA, you have one year to use the money that you have placed in your account.  Then once that year is up, any unspent money would be lost.

However, in light of recent events Congress and the IRS have passed a law that allows any unused money in your account to be rolled over from 2020 to 2021 and from 2021 to 2022.

Woop Woop!

The IRS has also allowed employers to extend benefits to children who may have "aged out" ,or turned 14, during 2020.

Qualifying Expenses

Here is a comprehensive list of all of your qualifying expenses.

What's Not Covered

Payment and Reimbursement Options

Submitting Claims

There are 3 ways that you can submit a claim for the Dependent Care FSA. All of which requires the signature of the dependent care provider or forms from the provider.

1. The dependent care provider must sign and certify the service rendered on the FSAFEDS app.
2. They must certify the service by signing the completed dependent care claims form. OR
3. You can submit a claims form with an itemized statement from the dependent care provider

Also, if you want your payments processed quickly make sure your receipts have the following: 

When submitting the PDF form, those can be done online or printed and mailed or faxed.  Payments are usually processed within 1-2 business days.

*Note: Provider's signature could replace need for separate documentation and other proof of service.

Reimbursement Options

For the Dependent Care FSA, they have what they call the "Pick and Process" reimbursement option where you can choose which expenses you want reimbursed and when.

When they receive your claim, it is processed and your money will be put in your account.

They do have an auto-reimbursement option in which once your claim is filed you are automatically reimbursed for eligible expenses.  Sadly, this option is only available for the Health Care FSA.

Payment Options

There are 3 payment options that the FSAFEDS offer:

• Pay Me Back - Direct Deposit 
• Pay Me Back - Check
• Pay My Provider

You can choose whichever option works best for you through your account online.  With the pay my provider, you must upload copies of your invoices or receipts.

The Pros and Cons of the Dependent Care FSA

The Pros

Saves You in Taxes

The biggest benefit that comes with having a Dependent Care FSA is the ability to save and use money tax-free.  By placing money in your FSA before taxes, you are able to reduce your tax burden while at the same time saving up for necessary expenses.

Just think, if you are in the 22% tax bracket and you put $5,000 into your Dependent Care FSA, you could save up to $1,100 in taxes!  Not to mention that your contributions to the FSA may cause you to fall into a lower tax bracket.

Which means, cha-ching, you will now only be taxed at the 12% rate!  Saving you 10% in taxes!

Talk about good financial planning!

You Can Stash a Good Chunk of Change

Having a Dependent Care FSA allows you to save up a good amount of money for your child and dependent care expenses.  And all of it tax-free!

Plus, with the new law changes for 2021, you can save even more.  $10,000 is no small amount so it may be best to take advantage of this offer while you can.

Saves You More in Social Security and Medicare Taxes

Money placed into your Dependent Care FSA not only saves you from paying federal and state taxes on it, but you also do not have to pay Social Security or the Medicare tax on it.

That saves you another 7.65% in taxes on the money you saved!

All these savings mean you can put all that extra money you are not paying in taxes to good use by investing it or paying down debt.

The Cons

If you don't use it, you lose it

The biggest downside to having a Dependent Care FSA is that if all of the money you put into it isn't used within the year, you lose the unused portion.

Now, I don't know about you but I'm pissed just thinking about my hard earned money going to waste like that.

Of course, one way to mitigate this risk is, if it is you first year using an FSA, to be conservative in the amount you save.  Then next year with a more accurate estimate of how much you will spend on expenses, you can adjust accordingly.  

Paying Out-of-Pocket

For the most part, even with money set aside in your Dependent Care FSA, you will probably have to pay for your child care expenses out-of-pocket.  Then later fill out a claims form to be reimbursed.

This is a bit of a hassle since you have to do extra work to get the money, you set aside for this very purpose, back.  It would be wonderful if you could just have a debit card linked to your account (like some HSA's), and pay with the debit card.

Alas, that is not the case here.  And while there is a payment option that allows you to pay provider directly, not all providers may be registered on the site.  

Plus, you would still have to fill out the claims form to get them to send the payment.

More Paperwork

While the form is really only one page and not very hard to fill out, it is extra work that you would have to do to get your money back.  And if you have lots of dependent care expenses, filling out those forms can get old pretty fast.

Not to mention all the receipts you will have to keep track of and submit for approval as well.

Not Flexible to Changes

Another downside of the FSA is that once you've decided how much you want taken out of your check every month, it is set in stone.  You can't make changes to your account or plan mid-year.

The only exception being this year with the new laws that Congress and the IRS introduced.  Since the savings limit has increased, you are allowed to increase how much is taken out of your salary.

What is the Child and Dependent Care Tax Credit?

The Child and Dependent Care tax credit aims to help people who have small children and/or dependents, that they are taking care of, by reducing their tax bill.

Remember refundable credits are the Holy Grail in the tax world as they reduce your bill $1 for $1 and can result in you getting money from the IRS even if you didn't pay any taxes.  And the Child and Dependent Care tax credit can be refundable (not always though!).

Who Can Claim the Child and Dependent Care Tax Credit?

In order to be eligible to claim this credit, you must have earned income for the tax year in question.  That earned income must be within the income limits and you must have paid someone to take care of your qualifying dependent in order for you to work, look for work, or be a full-time student.

Unfortunately, for 2021 anyone with an adjusted gross income of over $438,000 cannot claim this credit.

If you are married and living together, the only way to claim this credit is to file jointly.  But, if you are divorced or legally separated, you can claim this credit by filing with the Head of Household status.

If you are married and living apart, you may be able to claim this credit if the following apply:

• You file separate tax returns
• Your dependent lived with you for more than half the year
• You pay more than half of the bills
• Your spouse hasn't lived in your home for the past 6 months

These rules may also help those not legally separated.

Furthermore, to claim this credit, you must be making payments for child and dependent care to someone who is not your dependent, your spouse, or the parent of the qualifying child.

Qualifying Dependents

So who qualifies as dependents for this tax credit?  Well, it is pretty similar to those for the Dependent Care FSA.  

Eligible Expenses

The child and dependent care expenses that are eligible for the Child and Dependent Care tax credit are virtually the same as those for the Dependent Care FSA above.

However, for the tax credit, you can also claim money paid for food and lodging for your housekeeper.  

And payments made to relatives who aren't your dependents can also be claimed even if they live in your house as long as they are not your child who is under 19, your spouse, or the parent of the qualifying dependent.

How Does the Child and Dependent Care Tax Credit Work?

The Child and Dependent tax credit will be different for everyone.  That is because it takes into account your income as well as how much money you spent on dependent care.

For those who make less than $43,000, you can get a credit of up to 35% of your child and dependent care expenses.  If you make more than $43,000, you, you can get a credit of 20% on your expenses.  However, the IRS sets limits on the amount of expenses you can claim.

The Dollar Limit

The dollar limit for expenses paid in the year is, normally, $3,000 for one dependent and $6,000 for two or more dependents.

But, like the Dependent Care FSA, the American Rescue Plan Act (ARPA) has also increased the credit limits for the Child and Dependent Care tax credit for 2021.

Now, the credit goes up to $8,000 for one eligible dependent and up to $16,000 for two or more eligible dependents.

Dependent care benefits received from your employer reduces these amounts.  

For instance, should you decide to open up a dependent care FSA with your employer and put in $5,000 in 2021, you must subtract it from $8,000 (assuming it's only for one child) to arrive at your new dollar limit ($3,000). 

The Earned Income Limit

In addition the the dollar limit, the expenses that can be claimed for the dependent care tax credit is limited to the amount of earned income you have.  It cannot be higher.

So if you only make $2,000 for the year, you can only use $2,000 in claiming the tax and not $8,000 for one child.

ARPA Changes for 2021

Because of the pandemic, we've seen a lot of changes to our tax system in order to give people the financial relief that they need.  

Below we'll summarize the changes made to the Child and Dependent Care tax credit for 2021.  The adjustments made were to help lower and middle income families.  Check out these changes below.

• The credit is now fully refundable.  So even if you don't owe taxes, you can claim this credit and get money.
• The expense limits are now $8,000 for one dependent and $16,000 for two dependents or more
• The credit rate you can claim based on your income has increased.  See the table below.

All in all, the max amount of credit you can receive if you have one child is $1,050 (or $4,000 for 2021).  And with two or more children, that becomes $2,100 (or $8,000 for 2021).

That is a significant jump in credit for 2021!  So, if you have a child, you could potentially get a reduction in your tax bill of $8,000.  And if you are someone who doesn't owe taxes, you could get $8,000 back from the IRS for child care expenses.

You betta get that money honey!

But be aware that these numbers decrease the higher your income becomes.

How to Claim the Credit

To claim the Child and Dependent Care tax credit, you will need to complete Form 2441 - Child and Dependent Care Expenses.  This form needs to be submitted with your 1040 Form when you file your taxes.

Each qualifying dependent will need their own Social Security number or Taxpayer Identification Number (TIN).  And you will want to have kept your records up to date and organized.

Next, you will need information from the service provider.  You can send them a W-10 Form (Dependent Care Provider's Identification and Certification) to complete.  For the paperwork, you will need the provider's name, address, and TIN.  

If the provider doesn't complete the form or there is some misinformation, it could disqualify you from receiving the credit.  However, if you can show you made the effort (with proof, i.e. copies of provider's SSN number etc.) to try to get the information, you can still receive the credit.

For all my expats living abroad, your provider may not have a US TIN so you can simply write LAFCP (Living Abroad Foreign Care Provider) in the space provided.

Things to Note: 

• Your expenses cannot be more than your earned income (if you are married, use the spouse with the lower income).
• If you receive dependent care benefits from your employer (including a Dependent Care FSA), that reduces your dollar limit for the tax credit.
• It doesn't matter if only one child incurs expenses out of your two children.  You can still use the two or more expense limits when you claim the credit.

The Pros and Cons of the Child and Dependent Care Tax Credit

The Pros

It's a credit and not a deduction

While tax deductions are great, they are not much when compared to tax credits.  A deductions simply reduces the amount of your taxable income.  On the other hand, credits reduce your tax bill.

Giving you the potential to drastically reduce how much you owe the IRS.  And in some cases, can result in you getting a bigger tax refund.  Especially since for 2021, this credit is completely refundable.

This means huge savings or refunds are in the air for some of us!

Not Dependent on Your Employer

Another great plus for the tax credit is that anyone with dependents can claim this tax credit.  It doesn't depend on whether or not your employer offers it like the Dependent Care FSA.

As long as you have qualifying dependents and meet the requirements to be eligible for the tax credit, you can take it.

You Can Claim This Credit Abroad

It doesn't matter if you are in the states or currently living abroad.  You can claim the Child and Dependent Care tax credit where ever you are.

Definitely gets some bonus points for that!

No Income Limits (except for 2021)

Another beauty of the tax credit is that there are, typically, no income limits on it.  You can claim this credit regardless of how much income you make.

So no matter your income you can always claim this tax credit.  The only downside would be that the amount you can claim decreases the more you make.

**However, for 2021 there are income limits.  $437,999 to be exact.  But only time will tell if that will be the case for 2022.  After all, it may go back to its original rules.

The Cons

The Dollar, or Expense, Limit is a Bit of a Tease

At first glance, it may seem as if you can claim and get $3,000 of child care expenses for one child in tax credit.  But with a little more digging, you find out that $3,000 is the limit and in reality the maximum you can get is only a fraction of that.

I don't know about you but my feelings were hurt.  Getting a maximum of $1.050 in tax credit is a far cry from getting $3,000 (in 2020).

But hey, let's look at the upside!  Being able to get any tax credit at all is great because the less money you owe, the more money you get to keep.  And for 2021, you can get up to a max of $4,000 in tax credit!

The Credit Decreases for High Income Earners

Sadly, the tease of getting a full $3,000 in tax credit hurts even more as you earn a higher and higher wage.  At a certain point ($43k for 2020), the maximum you can receive in credit is $600 in 2020.

At that rate, maybe it is better to go with the Dependent Care FSA.

But 2021 is a special year and with the increase in credit limits and earning limits, it may be worth more to take the tax credit.

More Paperwork

What's worst than having to do more paperwork?  Having to do more paperwork during tax time. 

No one likes more work and that applies doubly when it comes to doing your taxes.  By choosing to take the Child and Dependent Care tax credit, you will have additional forms that you must fill out and submit if you want to get the credit.

Regular taxes are headache enough so you may not want the extra headache of having to fill out more forms.

Weighing in: Which is Better the FSA or the Tax Credit?

Typically, as your income increases the FSA is the better option.  And as your falls to a certain point, the tax credit would be the better option.

Let's check out a few cases below.

1. Low Income Earners

If you are in a lower income bracket, the Child and Dependent Care tax credit, may just give the most money back.  

As the amount of taxes you pay decreases, the amount of money you save with the FSA decreases as well.  Meanwhile, the amount tax credit you can receive increases.

For instance, if you are single with one child and making $30k a year, and you decide to put $5k in your Dependent Care FSA.  You can save a max of $982.50 in taxes (including Social Security/Medicare taxes).  

If you were to take the tax credit instead, you would save $810 in taxes normally.  But with the increases for 2021, you'd save $4,000 in taxes and probably qualify for a very large refund.

However, don't forget to take into account as low income earners you may qualify for other deductions and credits that could affect these results!

Tax Savings for $30,000 Income (Single/HoH/Joint Filing)

2. Middle Class Earners

If you are in the middle class, it may be better to choose the FSA under normal circumstances.  However, with the recent changes for 2021, it may be best for you to take the tax credit.

For example, if you are single with one child making $50k a year and you decide to put $5k into your FSA, you would save just under $1,400.  If you went the tax credit route, you would save just $600 in 2020.  But for 2021, you'd save $4,000.

In this case, for 2020, you should use the FSA, but for 2021 you should use the tax credit.

Tax Savings for $50,000 Income (Single/HoH/Joint Filing)

Now let's see what happens if you make $100k.  In that case, your FSA savings for $5k would be just under $1,600 while your tax credit would be $600 normally and $4000 for 2021.

For both cases if you had increased your FSA savings to $10k that would have brought your savings up a great deal (~$3k) but it looks like the tax credit would still win out.  Especially if you had two or more dependents.

Tax Savings for $100,000 Income (Single/HoH/Joint Filing)

3. High Income Earners

Usually, for high income earners, the Dependent Care FSA would save you the most money.  However, 2021 is a special year with lots of added benefits.  Will that change things up?  Let's take a look.

If you are making $200k with one child, and put $5k into your FSA, you would save almost $2,000 in taxes.  However, were you to take the tax credit, you would only save $600 normally and $1,600 in 2021.

That means the FSA is still the better bet.

But, whether you choose the FSA or the tax credit may come down to how many dependents you have.  That's because if you have two or more, the amount of credit you receive would double.  

And in this case, it would make the tax credit the better bet for 2021 (saving you $3,200).  

Of course, this result may not be the same for people making more than $200k as the tax credit decreases the more you make.

*Remember everyone's situation is unique and there may be other factors not taken into account such as marital status that could have a significant affect on the end result.

Tax Savings for $200,000 Income (Single/HoH/Joint Filing)

All in All

Deciding whether to go all in for the Dependent Care FSA or the Child and Dependent Tax Credit is a pretty difficult decision to make.  They both have some pretty great benefits, especially with those 2021 increases.

But I find it all comes down to the numbers.  So, before you can arrive at the best decision for you and your family, you might have to crunch some numbers.  

Which one gives you the best bang for your buck?