How does the tax system subsidize child care expenses?
Working parents are eligible for two tax benefits to offset child care costs: the child and dependent care tax credit and the exclusion for employer-provided child care.
The child and dependent care tax credit
The child and dependent care tax credit (CDCTC) provides a credit worth between 20 and 35 percent of child care costs up to $3,000 for a child under age 13 or any dependent physically or mentally incapable of self-care. Eligible child care expenses are limited to $6,000 per family. Higher credit rates apply to families with lower adjusted gross incomes (AGIs). Families with incomes below $15,000 qualify for the full 35 percent credit. That rate falls by 1 percentage point for each additional $2,000 of income (or part thereof) until it reaches 20 percent for families with incomes of $43,000 or more. The credit is nonrefundable so it can only be used to offset income taxes owed—in other words, any excess credit beyond taxes owed is forfeited. As a result, low-income families who owe little or no income tax get little benefit from the credit (table 1).
To qualify for the CDCTC, a parent must be working or in school. For married couples, both adults must be working or attending school. In general, allowable expenses are capped at the earnings of the lower-earning spouse. Special rules allow individuals who were students or disabled to have their earned income assumed to be $250 per month ($500 if there is more than one qualifying child).
The Urban-Brooking Tax Policy Center estimates that, in 2016, 12.7 percent of families with children benefited from the CDCTC. Some families with children will not benefit because they do not have child care expenses or, in the case of married couples, only one partner works or goes to school. Among families with children who benefit from the CDCTC, taxes will be reduced by an average of $551. The only income quintile in which families average substantially different benefits is the lowest. (Each quintile contains 20 percent of the population ranked by household income.) Not only are their child care expenses likely to be lower than those of families in higher-income quintiles, they are typically unable to benefit from the credit because the CDCTC is nonrefundable (figure 1).
Employer exclusion: flexible spending accounts
Employer-provided child and dependent care benefits include amounts paid directly for care, the value of care in a daycare facility provided or sponsored by an employer, and, more commonly, contributions made to a dependent care flexible spending account (FSA).
Employees can set aside up to $5,000 per year of their salary (regardless of the number of children) in an FSA to pay child care expenses. (FSAs are also available for health care expenses). The money set aside in an FSA is not subject to income or payroll taxes. Unlike the CDCTC, though, which requires both partners in a married couple to work to claim benefits, only one parent must work to claim a benefit from an FSA. In 2014, 39 percent of civilian workers had access to a dependent care FSA (Bureau of Labor Statistics 2014). Lower earners are less likely to have access to an FSA than higher earners (Stoltzfus 2015).
Interaction of CDCTC and FSAs
If a family has child care expenses that exceed the amount set aside in a flexible spending account, the family may qualify for a CDCTC. Families first calculate their allowable CDCTC expenses ($3,000 per child under age 13, up to $6,000 per family). If this calculation exceeds the amount of salary set aside in an FSA, a parent may claim a CDCTC based on the difference. For example, a family with two or more children can qualify for up to $6,000 of expenses to apply toward a CDCTC. If that family excluded $5,000 from salaries to pay for child care expenses in an FSA, it may claim the difference between the two ($1,000) for a CDCTC.
Higher-income families generally benefit more from the exclusion than from the credit because the excluded income is free from both income and payroll taxes. Most higher-income families with child care expenses qualify for a credit of 20 percent of their eligible expenses. Because the combined tax saving from each dollar of child care expenses excluded from income exceeds $0.20, the exclusion is worth more than the credit. The exclusion, however, is only available to taxpayers whose employers offer FSAs.
Neither the CDCTC nor the FSA are indexed for inflation. Thus, each year, the real (inflation-adjusted) value of benefits from the two provisions erodes.
Bureau of Labor Statistics. 2014. National Compensation Survey: Employee Benefits in the United States, March 2014. Bulletin 2779. Table 41. http://www.bls.gov/ncs/ebs/benefits/2014/ownership/civilian/table41a.htm.
Urban-Brookings Tax Policy Center. Microsimulation Model, version 0516-1.
Buehler, Sara J. 1998. “Child Care Tax Credit, and the Taxpayer Relief Act of 1997: Congress’ Missed Opportunity to Provide Parents Needed Relief from the Astronomical Costs of Child Care.” Hastings Women’s Law Journal 9(2): 189–218.
Stoltzfus, Eli R. 2015. “Access to Dependent Care Reimbursement Accounts and Workplace-Funded Childcare.” Beyond the Numbers: Pay & Benefits 4(1).
Burman, Leonard E., Jeff Rohaly, and Elaine Maag. 2005. “Tax Credits to Help Low-Income Families Pay for Child Care.” Tax Policy Issues and Options brief 14. Washington, DC: Urban Institute.
Dunbar, Amy E. 2005. “Child Care Credit.” In Encyclopedia of Taxation and Tax Policy, 2nd ed., edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, 53–55. Washington, DC: Urban Institute Press.
Internal Revenue Service. “Publication 503 – Main Content.” Washington, DC: Internal Revenue Service. Accessed November 23, 2015.
Maag, Elaine. 2005. “State Tax Credits for Child Care.” Washington, DC: Urban Institute.
———. 2014. “Child-Related Benefits in the Federal Income Tax.” Washington, DC: Urban Institute.
Maag, Elaine, Stephanie Rennae, and C. Eugene Steuerle. 2011. “A Reference Manual for Child Tax Benefits.” Perspectives on Low-Income Working Families brief 27. Washington, DC: Urban Institute.