Many companies have established optional Dependent Care Reimbursement Accounts to assist employees in handling the cost of child care or dependent care. Such accounts accumulate funds that allow the employee to pay those costs with pretax dollars.
Reimbursement accounts typically are handled through some sort of tax-free salary-reduction arrangement in which the employee elects to have the employer withhold up to $5,000 a year before taxes. As qualified dependent-care expenses are incurred, the employee submits receipts and receives a tax-free reimbursement from the account.
The Internal Revenue Service imposes a harsh "use-it-or-lose-it" requirement on reimbursement accounts. Any money remaining in the account at the end of a given period is forfeited.
Thus, the employee must carefully estimate the "qualified" expenses expected during the coming year. What are qualified reimbursable expenses? Typically, they are the same employment-related costs that would qualify for the dependent-care credit. The expenses must be incurred for or on behalf of a dependent under the age of 13 living in the taxpayer's residence, or a spouse or dependent if that person is physically or mentally incapable of caring for himself.
Such expenses in the home include baby-sitters, housekeepers and cooks. Costs for services outside the home might include day-care centers, nursery schools or after-school care at a public or private school.
The other alternative, the dependent-care credit, generally is 30 percent of up to $2,400 in employment-related or education-related expenses if the household has one qualifying person. The maximum goes up to $4,800 if the household has more than one qualifying person. The 30 percent guideline is reduced by one percentage point for each $2,000 (or fraction) by which adjusted gross income exceeds $10,000, but it cannot be reduced below 20 percent.
For example, an unmarried mother with adjusted gross income of $25,500 and two dependent children, ages 11 and 1, incurs $5,000 of employment-related child-care costs during the year. However, the maximum base, upon which the credit may be computed, is limited to $4,800. In this situation, the dependent-care credit will be limited to $1,056 (22 percent of $4,800).
The $2,400 or $4,800 limits on employment-related expenses are reduced dollar-for-dollar by the amount that is deducted in the reimbursement account. For example, if the mother in the above example had $2,000 withheld as part of a dependent-care reimbursement account, her credit would be limited to $616 (22 percent of $2,800).
Which alternative produces a more advantageous tax benefit depends on a number of factors, including the taxpayer's adjusted gross income, the tax bracket and the number of
Before making this important choice, an employee should get a calculator and play with the numbers.