The $ 1.9 trillion stimulus package known as the American Rescue Plan Act (ARPA) includes significant changes to the long-term child and dependent care loan (CDCC) with federal income tax.
Unless you’re in the high income category, the changes are cheap.
There’s a catch: the changes are temporary.
Here’s what you need to know after you’ve covered some necessary background information.
Basics of the child and long-term care loan (CDCC)
Taxpayers with one or more Qualified Individuals under their wing are eligible for the CDCC. The credit covers eligible expenses you pay to care for one or more qualified people so you can work, or if you are married, so both you and your spouse can work. If you are married, you will typically need to file a joint Form 1040 for the tax year in question to apply for the CDCC. However, some married but separate taxpayers are exempt from the joint filing requirement.
Qualified persons are your child under the age of 13, your stepchild, your foster child, your brother or sister, your step-sibling or a descendant of one of these persons. The person must live with you at home for more than six months and must not provide more than half of their own support. A disabled spouse or a disabled relative who has lived with you for more than six months can also be a qualified person.
Typical eligible expenses are payments to a daycare center, nanny or kindergarten. Overnight camp costs are not eligible. The costs for a private K-12 school are not qualified as these are viewed as educational costs rather than nursing costs. However, the cost of pre- and post-school programs may qualify. The cost of domestic help can also be qualified, provided that at least part of the cost is used to care for a qualified person.
Key point: Before the ARPA, the CDCC was non-refundable, meaning it could only be used to offset your federal income tax liability. If you didn’t have liability, you didn’t get credit. But for 2021 the balance will be refunded for most people as explained later.
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Cost limit
Before and after the ARPA switch, the eligible expenses must not exceed the income that you earn or that your spouse earns if you are married from work, self-employment or certain disability and retirement benefits. Generally, if you are married, you must use the income of the lower-income spouse for this restriction.
If a spouse has no earned income under the general restriction rule, you will not be able to claim the CDCC. However, if your spouse has no earned income and is a full-time student or a disabled person, he or she is assumed to have an imaginary monthly income of $ 250 if you have a qualified person, or an imaginary monthly income of $ 500, if you have two or more qualified individuals, individuals. In this exception, you may be able to benefit from the CDCC even though your spouse is not actually working and has no actual income.
Credit limit
Prior to the ARPA, eligible expenses (under the above limitation) could not exceed $ 3,000 for caring for one Qualified Person or $ 6,000 for caring for two or more Qualified Persons.
Before the ARPA, the maximum credit was 35% of eligible expenses when the taxpayer’s Adjusted Gross Income (AGI) for the year was $ 15,000 or less. For very low income taxpayers, the maximum credit was $ 1,050 ($ 3,000 x 35%) for one eligible person or $ 2,100 ($ 6,000 x 35%) for two or more.
Prior to the ARPA, for every $ 2,000 (or a fraction of) AGI in excess of $ 15,000, the loan rate was lowered by one percentage point until the interest rate bottomed out at 20%. Therefore, if your AGI exceeded $ 43,000, the loan rate was reduced to at least 20%. The maximum credit for those in this income bracket was $ 600 ($ 3,000 x 35%) for one Qualified Person or $ 1,200 ($ 6,000 x 20%) for two or more people.
Temporary tax friendly changes
For tax year 2021 only, ARPA is making the following temporary changes.
The credit may be refunded
For 2021, the CDCC will be reimbursed for taxpayers who have had their primary residence in the United States for more than half a year. In the case of a married couple with joint registration, each spouse can meet this requirement.
Credit can be much larger for most taxpayers
For 2021, the dollar eligible spending limits for recruiting the CDCC will be increased to $ 8,000 if you have one Qualified Person (from $ 3,000) and to $ 16,000 if you have two or more (from $ 6,000).
For the year 2021, the maximum lending rate will be increased from 35% to 50%.
However, the 2021 lending rate will decrease by one percentage point for every $ 2,000 (or a fraction of it) AGI of more than $ 125,000. Hence, if your AGI exceeds $ 183,000, the rate will be reduced to 20%. Before the ARPA, the AGI threshold for the loan rate reduction rule was only $ 15,000, and the interest rate was lowered 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 eligible person ($ 8,000 x 50%) and $ 8,000 for two or more eligible people ($ 16,000 x 50%). Before the ARPA, the maximum loan amounts were only $ 1,050 and $ 2,100, respectively.
For 2021, the maximum CDCC for a taxpayer with an AGI greater than $ 183,000 is $ 1,600 for one eligible person ($ 8,000 x 20%) and $ 3,200 for two or more eligible people ($ 16,000 x 20%). Before the ARPA, when the loan rate was lowered to 20%, the maximum loan amounts were only $ 600 and $ 1,200, respectively.
So far, so good.
Example 1: You are single In 2021, you will pay $ 15,000 in eligible expenses to care for your two qualified children so they can work. You can count the entire $ 15,000 to calculate your CDCC. Let’s say your 2021 AGI is $ 132,000. Your loan rate will be reduced from 50% to 46% since you have an AGI excess of $ 7,000. Specifically, the four percentage point reduction in the rate is because you have three times $ 2,000 in excess AGI plus a fraction of $ 2,000 in excess AGI. So your eligible CDCC is $ 6,900 ($ 15,000 x 46%). This helps.
The loan rate will be further reduced or eliminated for high income taxpayers
For 2021, the 20% loan rate applies if your AGI is between $ 183,001 and $ 400,000. Once your AGI exceeds $ 400,000, a second loan rate reduction rule comes into effect. The loan rate is reduced by one percentage point for every $ 2,000 (or a fraction thereof) of AGI greater than $ 400,000. Therefore, if your AGI exceeds $ 438,000, the rate will be reduced to 0%.
Example 2: Same as Example 1, except your 2021 AGI is $ 420,000 this time. Your loan rate will be reduced from 20% to 10% since you have an AGI excess of $ 20,000. Specifically, the ten percentage point reduction is due to the fact that you have an AGI excess of 10 x $ 2,000. So your eligible CDCC is $ 1,500 ($ 15,000 x 10%). Better than nothing.
Example 3: Let’s say your AGI is $ 438,500. Your loan rate will decrease 20% to 0% from $ 38,500 due to your AGI excess. Specifically, the 20 percentage point reduction is due to the fact that you have 19 x $ 2,000 in excess AGI plus a fraction of $ 2,000 in excess AGI. Therefore, due to your high income, the CDCC is completely phased out. We are sorry.
Liberalized CDCC vs. Liberalized Flexible Spending Account for Dependent Care (FSA)
For 2021, ARPA will also increase the maximum amount you can deposit into an Employer-Sponsored Flexible Spending Dependent Care Account (FSA) from $ 5,000 to $ 10,500. The contribution reduces your taxable salary for federal income and wage tax purposes (and usually also for federal income tax purposes, if applicable). Then you can make tax-free withdrawals to reimburse the chargeable costs for dependent care.
Depending on your specific circumstances, you may have dependent care expenses that are eligible for both the CDCC and FSA tax-free dependent care withdrawals. If you fall into this scenario, you can contribute a certain amount to a FSA for dependent care, collect the resulting savings in income and payroll taxes, and make tax-free withdrawals to reimburse yourself for eligible expenses.
You can then claim the CDCC under the CDCC rules for “excess” eligible expenditure, subject to the applicable CDCC eligible expenditure limit. To calculate your Eligible CDCC, complete IRS Form 2441 (Child and Care Expenses) and attach it to your Form 1040. The loan amount allowed is displayed on page 2 of the 1040 form.
Better forget about the FSA option and just request the CDCC? It depends on your income and other factors. Talk to your tax advisor.
The final result
The changes to the CDCC rules for the 2021 tax year are not easy. A related problem is how best to take advantage of both the CDCC and the Flexible Dependent Care Expense Account (FSA) option if your employer offers the FSA offering. That adds another level of complexity. Finally, note that in addition to taking advantage of the CDCC and FSA deals, you may be able to claim the 2021 child tax credit. That’s an incentive folks.
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