Ways Parents Can Save Money on Taxes

Parents know first-hand how expensive it is to raise a child.  New or expectant parents are often shocked and unprepared for the costs.    To soften the blow, it helps to know there are provisions in the tax code that offer cost savings to parents, specifically, Dependent Care Flexible Spending Accounts and Child Tax Credits.

Dependent Care Flexible Spending Accounts

Dependent Care flexible spending accounts, or FSAs, are a type of employee benefit plan offered by companies to help workers pay for child care expenses.  The employee still pays for these expenses, but does so with money that is never taxed.  This is called using “pre-tax money”.  It saves you money by reducing your tax bill.

An FSA is an account owned and managed by the employer who sets the rules based on IRS guidelines.  You, the employee, put money into the account each year through payroll deductions.  The maximum amount is determined by the IRS and is $2700 for 2020.  If you and your spouse both work for companies that offer dependent care FSAs, you can each contribute up to this limit.

Once there is money in the account, you can reimburse yourself for child care expenses you pay out of pocket. Expenses must be work-related – working as a volunteer or for nominal pay does not count.  If you are between jobs and looking for work, that counts as work-related.  Eligible expenses include the following for children under age 13:

• preschool
• day care
• babysitting, including paying a relative who is not your dependent
• summer day camp
• before/after school programs
• nannies and Au Pairs

If your company offers a dependent care FSA (not to be confused with a health care FSA which is a similar but separate account used for medical expenses), there will be an annual enrollment period near the end of the year.  At the time of enrollment you must carefully estimate your eligible child-care expenses for the coming year.

Remember, the company owns this account.  You generally cannot change the amount during the year, nor can you take it with you if you leave the company.  Any unspent money in the account at the end of the year is kept by the company, unless you elect to roll over up to $500.  Even with these potential traps, the FSA is a great way to save on taxes.  If a husband and wife each have access to an FSA at work and contribute a combined $5000, they would save $1200 in taxes if they are in the 24% tax bracket.

Child Tax Credits

Another tax-related tool available to parents, the child tax credit, is more straight-forward and does not require annual enrollment or filing receipts.  The benefit is available when you file your tax return as long as you pass the income test.

The good news is that since 2018 more parents are able to take advantage of this tax benefit because the income limits are much higher than under previous law.  The tax benefit is $2000 per child under age 17 but starts to reduce if income exceeds $200,000 for single filers and $400,000 for married filers.  (More good news: dependent children who are age 17 or older can qualify for a new $500 tax credit.)

The child tax credit is different than the dependent care FSA in several respects.  First, it reduces your tax bill dollar-for-dollar.  Say your total tax on combined income of $250,000 is $42,000 and you have two qualifying children, your tax bill would be $38,000 after $4000 in child tax credits ($2000 times 2 children).  Second, the credit is not tied to how much you spend on child care.  Third, it’s available to all parents whether working outside the home or not.

Nobody likes paying taxes, but with a little planning, especially in the case of an FSA, you can reduce your income tax bill and redirect the savings to your family.  And using one or the other of these tools is not mutually exclusive; you can take advantage of both if you qualify for them.