With the growth of single-parent and two-earner households, Congress created the child care credit to help cover the cost of child care you pay so you can hold down a paying job. If you're married, you and your spouse must both work to qualify for the credit, and the most expenses you can count toward the credit is the salary of whoever earns less. There's a special rule if your husband or wife is a full-time student or disabled. He or she is assumed to have sufficient earned income to qualify for the maximum allowable credit.
If you hire someone to come into your home to provide care, you may become an employer in the eyes of the tax law. That means you will have to pay the employer's share of the Social Security and Medicare taxes—which is 7.65% of wages paid—and possibly the federal unemployment tax as well. The tax you pay can be included in the amount on which you base your child care credit.
In response to IRS concerns that many parents were paying caregivers in cash and skipping the Social Security tax payments, Congress ordered that taxpayers who claim this credit report the name, address and Social Security number of the care provider. That will make it easy for the IRS to check whether Social Security taxes were paid and whether the care provider reports and pays tax on the income.
You can claim up to $3,000 of expenses that you paid for the qualifying care of one child under age 13 and up to $6,000 if you paid for the care of two or more children to enable you to work. The credit works on a sliding scale. Parents with income under $15,000 get a 35% credit (for a maximum credit of $1,050 for the care of one child and $2,100 for the care of two or more). The credit loses one percentage point for every $2,000 of income above that level until it levels off at 20% for those who make more than $43,000.
In addition to the $3,000/$6,000 caps on qualifying costs, the credit is limited by the amount of earned income you make during the year. (Earned income is basically income from a job or self-employment rather than from investments.) If you earn just $2,000 during the year, for example, that's the highest amount of child-care expenses you can count toward the credit. Congress doesn't want the IRS subsidizing your getaway from the kids if you're not earning taxable income.
The credit is based on what you pay for the care of a qualifying individual—including dependent children under age 13 or disabled dependents or a disabled spouse of any age—to enable you to work. The basic rules are the same whether care is provided for children or disabled dependents or spouses, but this discussion will focus on child care since it is the most common.
The government doesn't really care how much you spend, but there is a limit on how much of that expense qualifies for the credit. If you're paying for the care of one child under age 13, the first $3,000 you pay during the year qualifies. If you're paying for the care of two or more children under age 13, the amount doubles to $6,000.
When you send a child to a nursery school or a day-care center while you work, you can include the entire amount paid when figuring your credit—including the cost of meals provided as part of the care. The full cost of attending preschool might count, too, but when your child-care choice includes school for kindergarten on up, the part of the cost allocated to education is not a qualifying expense. If you pay for before- or after-school care, though, that cost can be included when computing your credit. Be sure to get an itemized bill.
What you pay for in-home child care counts, too. Even if your care-provider spends a good deal of his or her time on housekeeping chores and cooking, the entire salary is considered to be a qualifying cost as long as those services benefit the child being cared for so that you can work. The IRS draws the line at gardeners and chauffeurs, though. Also not counted toward the credit are amounts you pay to your child under age 19 or any dependent.
Remember that the person for whom care is provided must be your dependent. Thus, if your disabled father moves in with you and you hire someone to care for him while you work, the cost would qualify only if he is your dependent. When your child is involved, he or she must be under age 13. If the child reaches that age during the year, only amounts spent on care before the birthday count. In that case, though, the full $3,000 or $6,000 expense cap still applies.
There is also an exception to the general rule that you must be able to claim the child as a dependent on your return in order to qualify for the credit. This doesn't apply if you are divorced and have custody of the child but the noncustodial parent gets to claim the dependency exemption. Finally, if you are married, you must file a joint return to claim the credit, unless you otherwise qualify and your spouse did not live with you during the last six months of the year.
The law forbids "double-dipping'' from the child-care credit and employer child-care reimbursement plans. If your employer offers such a plan, you can funnel part of your pay through it to pay child care bills, a move that makes that part of your salary tax-free. But funds that go through a reimbursement account reduce — dollar for dollar — the amount of expenses that can qualify for the credit. Say, for example, that in 2006 you run $5,000 through such a plan to pay expenses for two qualifying children. That would reduce the maximum amount against which you could claim the credit to $1,000.
If you have the choice between the credit and a reimbursement plan for future child care expenses, the reimbursement plan is probably a better deal. For lower-income workers, however, it's possible that the credit will offer more tax savings.
If you paid child care expenses in 2006, you may be entitled to a credit on up to $6,000 of the expenses. If the expenses were reimbursed through your employer's dependent care benefit program, up to $5,000 of your salary may be excluded from your taxable wages. Here's how these tax breaks work.
First, the expenses must be for the care of a qualifying person. A qualifying person is a person who lived with you in 2006 and met one of these descriptions in 2006:
In addition, the expenses must be for qualified expenses, typically the cost of a day care center or babysitter. Private school (first grade and up), overnight camp, clothing and entertainment are NOT qualified expenses.
Finally, you must meet these requirements:
A few other noteworthy items:
The child tax credit is in addition to the child care credit and in addition to the tax savings delivered when you claim an exemption for a dependent child. For 2006, the child tax credit is worth $1,000 for each child you claim as a dependent who is under age 17 at the end of the year. If you have four children, the credit can cut your tax bill by $4,000.
The right to the child tax credit is phased out at higher income levels. The phase-out begins when adjusted gross income (AGI) passes $110,000 on a joint return, $75,000 on a single return or $55,000 if you're married filing separately. For every $1,000 (or fraction of $1,000) your AGI exceeds the trigger point, you lose $50 of credit. Say, for example, that you file a joint return and your AGI is $115,000. The $5,000 over the threshold would squeeze your credit by $250. If you have just one dependent child in 2005, your remaining credit would be just $750. If you have three children who qualify, though, your credits would be worth $2,750 ($3,000 - $250). The phase-out moves in $50 steps, not $50-per-child increments.