The $ 1.9 trillion stimulus package known as the American Rescue Plan Act (ARPA) includes major changes to the long-standing federal credit for children and dependents (CDCC).
Unless you are in the high income category, the changes are favorable.
There’s a catch: the changes are temporary.
Here is what you need to know, after you have covered some necessary basic information first.
Basics of child and dependent care credit
Taxpayers with one or more eligible persons under their wings are eligible for CDCC. The credit covers eligible expenses that you pay to care for one or more eligible people so that you can work, or if you are married, so that you and your spouse can work. If you are married, you generally have to file a spouse Form 1040 for the tax year in question to claim the CDCC. However, some married but separated taxpayers are exempt from the joint reporting obligation.
Eligible persons are defined as your child under 13, your stepson, your foster child, your brother or sister, your half-brother or a descendant of one of these persons. The individual must live with you for more than half of the year and must not provide more than half of their own support. A disabled spouse or disabled dependent who lives with you for more than half of the year may also be an eligible person.
Typical eligible expenses are payments to a daycare, nanny, or preschool. Costs for overnight camps are not eligible. K-12 private school costs are not eligible, as they are considered education expenses rather than care expenses. However, costs for before and after school programs may be eligible. Domestic help costs may also be eligible, provided that at least part of the cost is spent on the care of an eligible person.
Key point: Prior to ARPA, CDCC was non-refundable, meaning it could only be used to offset your federal income tax. If you had no responsibility, you have no credit. But for 2021, the credit is refundable for most people, as explained below.
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Limitation of expenses
Before and after the ARPA changes, eligible expenses cannot exceed the income you earn, or your spouse earns if you are married, from work, self-employment, or certain disability and retirement benefits. If you are married, you should generally use the income earned by the low-income spouse for this limitation.
So, according to the general rule of limitation, if one of the spouses has no earned income, you cannot apply for CDCC. However, if your spouse has no earned income and is a full-time or disabled student, they are deemed to have imaginary monthly earnings of $ 250 if you have a qualifying person or imaginary monthly earnings of $ 500 if you have any. two or more. people. Under this exception, you can potentially apply for CDCC even if your spouse is not actually working and receiving no actual income.
Before ARPA, eligible expenses (after the previous limit) could not exceed $ 3,000 for the care of one eligible person or $ 6,000 for the care of two or more eligible persons.
Prior to ARPA, the maximum credit was 35% of eligible expenses if the taxpayer’s Adjusted Gross Income (AGI) for the year was $ 15,000 or less. Therefore, for taxpayers with very modest incomes, the maximum credit was $ 1,050 ($ 3,000 x 35%) for one qualifying person or $ 2,100 ($ 6,000 x 35%) for two or more persons.
Prior to ARPA, the lending rate was reduced by one percentage point for every $ 2,000 (or fraction thereof) of AGI in excess of $ 15,000 until the rate hit a floor of. 20%. Thus, the credit rate was reduced to a minimum of 20% if your AGI exceeded $ 43,000. The maximum credit for people in this income category was $ 600 ($ 3,000 x 35%) for one qualifying person or $ 1,200 ($ 6,000 x 20%) for two or more people.
Temporary changes favorable to taxpayers
For the 2021 tax year only, ARPA is making the following temporary changes.
The credit is potentially refundable
For 2021, CDCC is refundable to taxpayers who have a primary place of residence in the United States for more than half of the year. In the case of a married couple declaring jointly, either spouse can meet this requirement.
Credit can be much more important for most taxpayers
For 2021, the dollar limits on eligible expenses to claim CDCC are increased to $ 8,000 if you have one eligible person (instead of $ 3,000) and $ 16,000 if you have two or more (instead of $ 6,000).
For 2021, the maximum credit rate is increased to 50% (instead of 35%).
But the 2021 lending rate is reduced by one percentage point for every $ 2,000 (or fraction thereof) of AGI that exceeds $ 125,000. Thus, the rate is reduced to 20% if your AGI exceeds $ 183,000. Prior to ARPA, the AGI threshold for the credit rate reduction rule was only $ 15,000, and the rate was reduced to 20% if your AGI exceeded $ 43,000.
For 2021, the maximum CDCC for a taxpayer with an AGI of $ 125,000 or less is $ 4,000 for one qualifying person ($ 8,000 x 50%) and $ 8,000 for two or more qualifying persons (16 $ 000 x 50%). Prior to ARPA, the maximum credit amounts were only $ 1,050 and $ 2,100, respectively.
For 2021, the maximum CDCC for a taxpayer whose AGI is greater than $ 183,000 is $ 1,600 for an eligible person ($ 8,000 x 20%) and $ 3,200 for two or more eligible persons ($ 16,000 x 20%) . Prior to ARPA, the maximum credit amounts when the credit rate was reduced to 20% were only $ 600 and $ 1,200, respectively.
So far, so good.
Example 1: You are single. In 2021, you pay $ 15,000 in eligible expenses, for the care of your two eligible children, so that you can work. You can count the full $ 15,000 to calculate your CDCC. Suppose your AGI 2021 is $ 132,000. Your credit rate is reduced from 50% to 46% due to a $ 7,000 excess in AGI. Specifically, the four percentage point rate reduction is due to the fact that you have three x $ 2,000 of excess AGI plus a fraction of $ 2,000 of excess AGI. So your eligible CDCC is $ 6,900 ($ 15,000 x 46%). Who helps.
Credit rate is further reduced or eliminated for high income taxpayers
For 2021, the 20% credit rate applies if your AGI is between $ 183,001 and $ 400,000. But once your AGI exceeds $ 400,000, a second credit rate reduction rule takes effect. The credit rate is reduced by one percentage point for each $ 2,000 (or fraction thereof) of AGI in excess of $ 400,000. Thus, the rate is reduced to 0% if your AGI exceeds $ 438,000.
Example 2: Same as Example 1, except this time your AGI 2021 is $ 420,000. Your credit rate is reduced from 20% to 10% due to your excess of $ 20,000 in AGI. Specifically, the 10 percentage point reduction is because you have 10 x $ 2,000 in excess AGI. So your eligible CDCC is $ 1,500 ($ 15,000 x 10%). Better than nothing.
Example 3: Now let’s say your AGI is $ 438,500. Your credit rate is reduced from 20% to 0% due to your excess AGI of $ 38,500. Specifically, the 20 percentage point reduction is due to the fact that you have 19 x $ 2,000 of excess AGI plus a fraction of $ 2,000 of excess AGI. So CDCC is completely removed due to your high income. Sorry.
Liberalized CDCC vs Liberalized Flexible Expenditure Account for Dependent Care (FSA)
For 2021, ARPA is also increasing the maximum amount you can contribute to an employer-sponsored flexible dependent care expense account from $ 5,000 to $ 10,500. The contribution reduces your taxable salary for federal income tax and payroll tax purposes (and generally for state income tax purposes, if applicable). Then you can make tax-free withdrawals to reimburse you for eligible child care expenses.
Depending on your particular situation, you may have dependent care expenses that are eligible for both CDCC and FSA withdrawals for tax-free dependents. If you fall into this scenario, you could contribute a certain amount to a Dependent FSA, collect the resulting income and payroll tax savings, and make tax-free withdrawals to reimburse you for expenses. eligible.
You may then claim from CDCC “excess” Eligible Expenses under CDCC Rules, subject to CDCC’s applicable limit on Eligible Expenses. To calculate your eligible CDCC, complete Form IRS 2441 (Child Care and Dependents Expenses) and include it with your Form 1040. The eligible credit amount will appear on page 2 of Form 1040.
Is it better to forget the FSA option and simply claim the CDCC? It depends on your income and other factors. Talk to your tax professional.
The bottom line
The changes to CDCC’s rules for the 2021 tax year are not straightforward. A related question is how to get the most out of the CDCC option and the Flexible Dependent Expense Account (FSA) if your employer offers the deal with the FSA. This adds another layer of complexity. Finally, be aware that you may be able to claim the Child Tax Credit for 2021 in addition to taking advantage of the CDCC and FSA agreement. It’s a stimulus, folks.
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