The 2021 Daycare Credit (Child and Dependent Care Credit)

This change in the latest COVID stimulus bill has not gotten enough attention.

Here's a headline: A credit that was worth, at most, $1200 for most people is now worth up to $8000 for a heck of a lot more people.

Do I have your attention?

First, a bit about how the credit works:

For most people, you put your kid(s) in daycare so you (and your spouse) can go to work. You get a statement from the daycare and you put it on your tax return. With one kid, you get a credit for up to $3000 in expenses, with two or more kids, you get a credit on up to $6000 of expenses. A little understood fact is that if you have two or more qualifying kids, you get the $6000 limit even if it is all spent on one child. Remember a credit reduces taxes dollar for dollar, while a deduction reduces income. Credits are better.

Here are the details for the non-obvious cases:

1. People for whom expenses qualify are: children under the age of 13 (expenses apply right up to the day they turn 13), your spouse if he/she is unable to care for themselves, and anyone else who lives with you for more than half the year for whom you can claim as a dependent (unless the reason you can't is income over $4300, they file a joint return, or you could be claimed as a dependent) who cannot take care of themselves. 

2. Expenses have to be for you to work, look for work or go to school full-time. They have to be connected to these requirements by time (more on that later) but in reality, the main technique for determining this is to take your earned income (wages and net business income mostly), your spouses earned income, and the daycare expenses, then take the smaller of the three. In 90% of cases, this does the trick properly.

3. If you or your spouse are a full time student, for at least 5 months of the year, you can add $250 per month ($500 if you have two or more qualifying individuals) that you were a full time student, but this is where the timing thing comes in, if you have income during a month, you use the income, or the $250/$500 number, whichever is lower.

4. If you have earned income, but your spouse is disabled, you can use the $250/$500 discussed above for each month your spouse is disabled. You can't both use the disabled trick, one of you needs earned income.

5. Technically, if you and your spouse took a 3 month vacation and paid daycare so you could enjoy it, and then went back to work and had tons of earned income, only the daycare paid while you were working counts. Short, normal work breaks for vacation or illness are okay.

6. Day-camps count for the credit, but not overnight camps. Even day camps with specific activities like sports or music. School before kindergarten counts but no schooling once kindergarten starts counts, but afterschool care does. The school should separately state expenses for school/aftercare.

7. You can't get this credit if you file Married Filing Separately.

8. Only the custodial parent can get this credit. If the child doesn't live with you half the year, you get nothing.

9. There are a lot more rules about daycare centers, who you can pay, and more. Seek professional help if your situation is not obvious. This is a broad strokes overview!

Here is the 2020 calculation:

$3000 max in expenses for one child. $6000 for two children. Get a credit for 35% of expenses if income (technically AGI) is below $15,000, then it drops quickly by 1% every $2000 of income until it hits 20% of expenses, where it stays forever. You cannot use this credit once your taxes hit zero.

Here is the 2021 calculation:

$8000 in expenses for one child. $16000 for two children. Credit of 50% of expenses if income is below $125,000, then it drops to 20% as income goes up to $185,000, where it stays until income hits $400,000, where it quickly drops to zero as income gets to $440,000. Here is the BIG DEAL: You can get this credit even after your taxes hit zero.

Some additional thoughts:

1. A Daycare Flexible Spending Account looks like a bad deal this year, except that it reduces AGI for other calculations. In a year where keeping income below $75,000 Single, $112,500 Head of Household and $150,000 Married Joint is a big deal for children, reducing AGI might be nice.

2. If you are close to these income limits, hammer money into your 401k and HSA if possible to get below them.

3. Divorcing couples with kids in daycare need to have a frank talk about filing jointly rather than separately. Similarly, custodial and non-custodial parents should talk about maximizing this credit by controlling who pays what expenses.

4. If you are a stay at home parent thinking about going back to school, 2021 might be the year it makes sense.