ARPA Adds Dollars to the Child and Dependent Care Tax Credit

The new American Rescue Plan Act (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.

CDCC Basics

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 more than 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 more than 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 educational 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 child.

Key point. Except for in the tax year 2021, the CDC is non-refundable. That means you can use it only to offset your federal income tax liability. If you have no liability, you get no credit.

Expense Limitation

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.

Credit Limitations

Except for the 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 the 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 is reduced to 20 percent are only $600 and $1,200, respectively.

Example 1. You are unmarried. In 2021, you pay $16,000 of eligible expenses for the care of your two qualifying children so you can work. You can count the $16,000 in calculating your allowable CDCC.

Say your 2021 AGI is $132,000. Your credit rate is reduced from 50 percent to 46 percent due to $7,000 of excess AGI. Specifically, the four-percentage-point rate reduction is because you have three X $2,000 of excess AGI plus one fraction of $2,000 of excess AGI. So, your allowable CDCC is $7,360 ($16,000 x 46 percent). Take it!

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.

Example 2. Same as Example 1, except this time, let’s say your 2021 AGI is $420,000. Your credit rate is reduced from 20 percent to 10 percent due to $20,000 of excess AGI. Specifically, the 10-percentage-point rate reduction is because you have 10 X $2,000 of excess AGI. So, your allowable CDCC is only $1,600 ($16,000 x 10 percent). Still, that’s better than nothing. Don’t spend it all in one place.

Example 3. Now let’s say your 2021 AGI is $439,000. Your credit rate is reduced from 20 percent to 0 percent due to $39,000 of excess AGI. Specifically, the 20-percentage-point rate reduction is because you have 19 X $2,000 of excess AGI plus one fraction of $2,000 of excess AGI. So, the CDCC is completely phased out due to your high income. Sorry about that.

Measuring the Liberalized CDCC for 2021 against the Liberalized Dependent Care Flexible Spending Account Deal for 2021

For the tax year 2021, the ARPA also increased the maximum amount that you can contribute to an employer-sponsored dependent care flexible spending account (SFA) 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.

Depending on your specific circumstances, you can have dependent care expenses that are eligible both for the CDCC and for tax-free dependent care FSA withdrawals.

If you fall into this category, 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 CDCC for “excess” eligible expenses under the CDCC rules, subject to the applicable CDCC limit on eligible expenses. To calculate your allowable CDCC, fill out IRS Form 2441 (Child and Dependent Care Expenses) and include it when you file your 2021 Form 1040 sometime next year.

The allowable CDCC amount will show up on page 2 of your Form 1040.

Are you better off forgetting about the FSA option and just claiming the CDCC? It depends on your income and other factors. Get out your calculator and run the numbers.

Takeaways

At first glance, the ARPA changes to the CDCC rules for your 2021 tax year might seem pretty simple.

On second glance, maybe not. Sorry! “Simple” is not in the tax code cards these days.

A related issue, if your employer offers an FSA plan, is how best to take advantage of the CDCC and the dependent care FSA  deal. We would not blame you for hiring a tax pro to help you get the best tax savings to result in your specific situation.

Finally, you may qualify for both credits — the more generous CDCC and the more generous child tax credit — for 2021. For the new 2021 benefits from the child tax credit, see ARPA Adds Cash to the Child Tax Credit (2021 Only). If so, you could be in line for an unexpected windfall.

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