The Child and Dependent Care Credit (“CDCC”) is not new, but the American Rescue Plan Act of 2021 (“ARPA”) makes some serious changes that can drastically expand this tax credit for many taxpayers (and completely eliminate it for others) for the 2021 tax year.
Some Background on the CDCC
The CDCC has been around for a while (if you have kids, your accountant has probably asked you how much you spent on daycare, after-school programs, pre-school, etc.). Prior to the ARPA’s enactment, the CDCC allowed you to take a tax credit for a certain percentage of up to $3,000 of childcare expenses for one qualifying child and up to $6,000 for two or more qualifying children. The percentage that you used to determine the amount of your credit ranged from 20% to 35% (depending on your income level). If your adjusted gross income (“AGI”) exceeded $43,000, you were getting a credit equal to 20% of your expenses, which came out to $600 for one child and $1,200 for two or more children.
The ARPA Expanded the CDCC for Some Taxpayers…
- The maximum eligible expenses (previously $3,000 and $6,000 for one/more than one kid) has been increased to $8,000 and $16,000
- The maximum credit percentage is up from 35% to 50%
- The phase-out of the percentage is higher, so instead of hitting the minimum 20% when your AGI exceeds $43,000, you won’t hit the 20% rate until your AGI exceeds $183,000
- The phase-out also starts higher, so you will get the maximum 50% rate until your AGI hits $125,000
What does this mean in dollars? If you have two qualifying children, your AGI is $183,000, and you had $10,000 of eligible care expenses for each child:
- Pre-ARPA – Your credit would be 20% of $3,000 per child, so $1,200
- Post-ARPA – Your credit would be 20% of $8,000 per child, so $3,200
If your AGI was $125,000 instead of $183,000 (meaning your credit rate is 50%, not 20%), your credit (Post-ARPA) would be calculated as 50% of $8,000 per child, so $8,000!
…and Eliminated It for Others
Prior to the ARPA, the 20% rate threshold was a true minimum, however, the ARPA enacted a further phase-out that kicks in at an AGI of $400,000 and completely phases the rate down to 0% once your AGI gets to $438,000.
Another Related Change (to Your Dependent Care FSA)
You may be used to putting $5,000 pre-tax (per family, not per taxpayer) into your Dependent Care FSA, which you then used to cover many of these types of expenses. For 2021 the ARPA increased the maximum contribution from $5,000 to $10,500. If you have enough expenses (and children) to use your whole FSA balance and more, you can use the excess expenses (up to the maximum of $8,000 per child) to claim the CDCC.
Planning Note – Depending on your AGI, tax rate, and other factors, you may actually be better off claiming the CDCC (at a rate of up to 50%) then you would be contributing to a pre-tax FSA. This is definitely something to discuss with your accountant now, not at year-end when it will be too late to make any changes!
Some Technical Stuff (if You’re Curious)
- Qualifying Individual – A qualifying individual (I used the word “children” above, but the credit is not limited to just children) is defined as your under-age-13 child, stepchild, foster child, sibling, step-sibling, or descendant or any of these individuals. To qualify, the individual must live in your home for over half of the year and must not provide half of their own financial support. A disabled spouse or dependent who lives with you for over half of the year can also qualify
- Eligible Expense – Eligible expenses include payments to a daycare center, nanny (on the books, of course), nursery school, before/after-school programs, classes (yes, even the music class that your 4-month old sleeps through), etc. Note that costs for sleepaway camp do not qualify
- Limitation Based on Earned Income – The eligible expenses mentioned above are limited to your and your spouses earned income (whichever is lower). This means that if you or your spouse don’t work, your expenses will be limited to $0, so you won’t be eligible for this credit. Note that there are exceptions for if one spouse is a full-time student or disabled.
- How the Phase-Out Works – Both phase-outs ($125k to $183k and $400k to $438k) are determined by starting at the maximum percentage (50% and 20%, respectively) and decreasing the percentage by one percentage point (rounded up) for every $2,000 that your AGI exceeds the minimum. For example, if your AGI is $132,000, your AGI exceeds $125,000 by $7,000. $7,000 divided by $2,000 = 3.5, which gets rounded up to 4. You must decrease your percentage from 50% to 46%.
- Refundable vs. Non-Refundable – Prior to the ARPA this credit was non-refundable, meaning if you did not have any federal tax you were not able to claim this credit. The ARPA made this credit refundable for 2021.
- Temporary Changes – Note that many of the changes made by the ARPA are temporary and will not last into 2022 unless further action is taken to extend these changes
There was a lot to absorb here (nothing’s ever simple), but this change will help out many taxpayers by expanding their child care tax credit. Coupled with the expanded Child Tax Credit (not discussed here because this is long enough already), 2021 could see many taxpayers with an unexpected bump to their refund come tax time.
The topic discussed here is complicated and developing. Always consult your tax advisor about your specific situation before taking action.