Learn more about the different kinds of credits that can offset your tax expense.
A reason to pay the nanny tax
By properly paying employment taxes you can claim credits that will cut down on the expense by up to $1,600. You will need to choose between using a Dependent Care Flexible Savings Account (FSA) or claiming the Dependent Care Tax Credit.
Generally, if your income is above $24,000, the FSA results in a bigger tax savings. Your employer must provide one to take advantage of it. The requirements and differences between the two methods are described below.
For each of these options, the major eligibility requirements are:
- The childcare expense allows you to work. If married, your spouse must also be employed or a full-time student.
- The expenses cannot exceed your earned income, or your spouse’s if married.
- The child or children receiving care are 12 or under.
- You can only claim one credit for a particular amount of expense, meaning you cannot claim both credits for the same $2,000 in pay to your nanny. However, you can use a FSA for the first $5,000 of childcare expense, and then claim the Dependent Care Credit on the next $1,000.
The Dependent Care Flexible Savings Account
A FSA is an account that is set up by your employer that allows you to save up to $5,000 of your paycheck before any taxes are taken out. When that money is spent on a qualified expense, such as childcare, you can avoid paying federal income, social security, medicare, and state income tax on that amount. The higher tax bracket you are in, the more this credit is worth.
While a FSA can potentially save you more, there are some drawbacks to consider. Your employer must offer this kind of account, and you can only sign up for one during benefit open enrollment (Note: a birth or adoption is a qualifying event that should allow you to make benefit changes). You will have to fill out additional paperwork to setup the account and then again to have your nanny expenses reimbursed from this account. Keep in mind that any leftover funds are forfeited at the end of year if not used. So it is important to plan your FSA contributions accordingly. If you make more than $110,000 per year, then your FSA contributions are capped at $1,800.
The Dependent Care Tax Credit
This tax credit can be a good choice if your employer does not offer a FSA or you are in a lower tax bracket. You can take a 20% to 35% credit on childcare expense of up to $3,000 for one child or $6,000 for two or more. The percentage of the credit drops as income rises. It starts at 35% for adjusted gross incomes below $15,000 and drops 1 percent for every $2,000 increase in income. The 20% credit applies to households with adjusted gross incomes over $43,000.
The advantage of the Dependent Care Tax Credit is convenience. Just keep track of your nanny expenses and answer a few questions at tax time. Tax preparation programs such as TurboTax or TaxCut will guide you through the questions. If you are doing your taxes yourself, you can attach Form 2441 – Child and Dependent Care Expenses to your Form 1040 (or 1040A or 1040NR, but not 1040EZ).
How to get the biggest tax credit
For those with one child, the FSA will likely be the best choice. For families with two or more children and childcare expenses over $6,000, the best tactic is to contribute $5,000 into a dependent care FSA from your employer, and then claim $1,000 of additional expense through the Dependent Care Credit when you file your taxes.
Next step: Tax Time