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Navigating Changes to the 2021 Dependent Care Credit

The Dependent Care Credit is available to taxpayers who pay someone else to care for a dependent under age 13 or to care for a spouse or dependent who is unable to care for themselves. The goal of the credit is to help subsidize dependent care expenses so the taxpayer is able to work or look for work.

Much like the Child Tax Credit, significant changes have been made to the Dependent Care Credit for just one year, effective in 2021. Here’s a review of these changes:

Prior to 2021 In 2021
The maximum dependent care expenses eligible for the credit are $3,000 for one dependent or $6,000 for more than one dependent. The maximum expenses eligible have increased to $8,000 for one dependent and $16,000 for more than one dependent.
The credit rate is 35% of eligible expenses for taxpayers whose modified adjusted gross income (MAGI) is up to $15,000. The credit rate increases to 50% of eligible expenses for taxpayers whose MAGI is up to $125,000.
The credit reduces by 1% for every $2,000 of AGI after the $15,000 threshold. For taxpayers with $43,000 in AGI or higher, the credit is 20%. The credit slowly reduces to 20% for taxpayers with an AGI between $125,000 and $185,000. After that, the credit is 20% for up to $400,000 in AGI. Beyond $400,000, the credit starts phasing out to zero.
The credit is non-refundable. The credit is fully refundable if the taxpayer or spouse has a principal place of abode in the US for more than half of the year.
Dependent Care Flexible Spending Accounts allow pretax contributions of up to $5,000 for single taxpayers and married joint filers. Dependent Care Flexible Spending Accounts allow pretax contributions of up to $10,500* for single taxpayers and married joint filers.

*Note: For married taxpayers filing separately, the limit is $5,250 in 2021 only (up from $2,500). These contribution limits are still subject to income thresholds for highly-compensated employees.

For lower to middle income taxpayers, these changes can result in a huge increase in tax credit! Many higher income taxpayers will also benefit from the usual base credit of 20% (up to that $400,000 AGI threshold). These nuances demonstrate how essential it is to plan ahead for 2021 income taxes and anticipate how these different enhanced credits could impact a taxpayer’s return.

Here’s a practical example: Daniel is the head of household with an AGI of $115,000. He has a son who is 3-years-old, and he spends $10,000 in childcare each year so he can work full-time. His employer doesn’t provide a dependent care benefit. For tax year 2020, Daniel would only receive a credit of $600 because the maximum expense is $3,000 and the credit rate is 20%. However, for tax year 2021, Daniel’s credit would be $4,000 because the credit rate is 50% and the maximum eligible amount is $8,000. So you can see the dramatic increase in benefit for taxpayers within a similar income range.

Our takeaway: With the major tax credit increases and income threshold changes occurring in 2021, savvy taxpayers will want to consult a tax expert well in advance to ensure that they understand how to take advantage of all of these benefits.

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