Anyone with children can tell you that child care is expensive — really expensive. According to the Children's Defense Fund, the average day-care center charges $4,000 to $6,000 annually for a four-year-old child. Infant and toddler care is even pricier. And in some cities, child care is so pricey that it costs twice as much as a year's worth of public college tuition.
Of course, other than quitting your job or begging a family member to watch your kids for free, there isn't much you can do to dramatically lower your child-care expenses. But you can certainly soften the blow by participating in an employer-sponsored dependent-care flexible-spending account, also known as a "cafeteria plan." More than 90% of employers offer such plans, according to Hewitt Associates, a Lincolnshire, Ill.-based benefits-consulting firm. (Another type of flexible-spending account can be used for medical expenses; Check out FSA calculator for more on this.)
A dependent-care account allows working parents (stay-at-home moms don't qualify) to use pretax dollars to pay for work-related child-care expenses, such as baby-sitting or day care, for children under the age of 13. Expenses for disabled and elderly dependents requiring adult day care also qualify. For someone in the 25% federal-tax bracket, this means saving about $31 of every $100 of expenses (taking into account the additional savings you receive by avoiding the 5.65% Social Security and Medicare taxes). And in many states, the savings are even greater, since dependent care account contributions are often exempt from state and local taxes.
Unfortunately, if one parent works while the other stays at home (assuming the parents are married), even the working parent can't participate in this type of plan. Also, while it might be tempting to try and pass off some extra expenses — such as the occasional evening baby-sitter so you and your spouse can have some much-needed time alone — only those child-care fees that specifically allow parents to work will qualify. (You'll need documentation for both your employment status and your expenses — so don't try to fudge it.)
How do these plans work? Every year your employer will ask you how much you'd like to contribute from your pretax income into the account. The federal limit is $5,000 per family (this is the cap for married couples or single parents), regardless of how many young children are in the family. Each pay period, your employer will deduct a proportionate amount from your paycheck. While this means you won't have the total contribution taken out of your income until the end of the year, you can spend and get reimbursed for the full amount that you've allotted at any time. So if you need to pay the Pumpkin Patch's winter tuition in January, you can still use your pretax dollars to pay for those expenses. All you have to do is submit the bill to your employer and provide a taxpayer identification number or Social Security number of the individual or child-care center when you file your federal-income-tax return. (That means that if you pay your nanny under the table, you're out of luck.)
Be warned: You don't want to overestimate your expenses. Should you set aside more than you actually spend, you'd be forced to forfeit the extra amount. Also, if you leave your job, voluntarily or not, you'll have to give up any unused contributions year-to-date.
Our calculator will tell you how much you stand to save by participating. In order to get an accurate estimate, you'll need to know your tax bracket. For a tax-rate schedule for single filers click here. Joint filers can click here.
* This is just an estimate. Tax savings will vary somewhat for those earning more than $110,100 in 2012 since any income above that threshold is only subject to a Medicare tax of 1.45% (2.9% if self-employed). In other words, the 4.2% Social Security tax (10.4% for those who are self-employed) doesn't apply to earnings above the $110,100 level.
So what if your employer doesn't offer this benefit? The only tax-friendly alternative is the child-care tax credit, which allows working parents to recover a percentage of their child-care expenses. The amount is determined by multiplying your child-care expenses (the limit for one child is set at $3,000 and for two or more kids the limit is $6,000) by a certain percent, based on income. For example, those making $15,000 can receive a credit equal to 35% of expenses for a maximum tax break of $1,050 for a single child or $2,100 for two or more kids. The credit percentage falls to 20% for families earning $43,000 or more. Most families earning $43,000 and up will be better off with a dependent care account (if available) than claiming the credit.