Everything Families Need to Know about the Child Care Tax Credit

One of the benefits of paying your nanny legally is taking advantage of the tax breaks from Dependent Care FSAs and the Child and Dependent Care Tax Credit. Under the American Rescue Plan Act (ARPA), these tax savings could more than cover your nanny tax obligation. In other words, it can save you money by paying “on the books” rather than “under the table.”

Wages paid to a nanny is a qualifying expense for both a Dependent Care FSA and the Child and Dependent Care Tax Credit.

Within a renewed interest in the expanded Child and Dependent Care Tax Credit, the IRS recently updated its FAQs to help families claiming the credit under ARPA. Here’s everything you need to know about the Child and Dependent Care Tax Credit. Here we focus on families who have hired a nanny to provide in-home childcare or may have some hybrid childcare situation like a combination of nanny care, daycare centers, summer camps, and/or after-school care. Read the complete IRS FAQs for information on claiming other dependents under the tax credit.

Child and Dependent Care Tax Credit Overview

The Child and Dependent Care Credit is a tax credit that may help you pay for the care of eligible children and other dependents. The credit is calculated based on your income and a percentage of expenses that you incur for the care of your children to enable you to go to work, look for work or attend school. For 2021, the ARPA made the credit substantially more generous (up to $4,000 for one child and $8,000 for two or more children) and potentially refundable – so you might not have to owe taxes to claim the credit (so long as you meet the other requirements). This means that more taxpayers will be eligible for the credit for the first time and that, for many taxpayers, the amount of the credit will be larger than in prior years.

However, taxpayers with an adjusted gross income over $438,000 are not eligible for this credit even though they may have previously been able to claim this credit.

Am I eligible to claim the Child and Dependent Care Tax Credit?

You are eligible to claim this credit if you (or your spouse in the case of a joint return) pay someone to care for one or more children in order for you to work or look for work, and your income level is within the income limits set for the credit. If you are married, you must file a joint return to claim the credit. However, if you are legally separated or living apart from your spouse, you may be able to file a separate return and still claim the credit. If you or your spouse was a full-time student, see IRS Publication 503, Child and Dependent Care Expenses, for more information on eligibility.

How do I claim the Child and Dependent Care Tax Credit?

To claim the credit, you will need to complete Form 2441, Child and Dependent Care Expenses, and include the form when you file your federal income tax return. In completing the form to claim the credit, you will need to provide each child’s Social Security Number (SSN).

What information do I need from my nanny to claim the credit?

You must identify all persons (like a nanny) or organizations (daycare centers, summer camps, etc.) that provided care for your child. To identify a nanny, you must give their name, address, and SSN or Individual Taxpayer Identification Number (ITIN). You can use Form W-10, Dependent Care Provider’s Identification and Certification to request this information. If your nanny’s information is incorrect or incomplete, your credit may not be allowed. However, if you can show that you used due diligence in trying to supply the information, you can still claim the credit.

You should keep this information with your tax records.

Who is a qualifying person?

A qualifying child is defined as your dependent who is under age 13 when the care is provided.

For 2021, what percentage of my work-related expenses are allowed as a credit?

The percentage of your work-related expenses allowed as a credit depends on your income (and your spouse’s income in the case of a joint return). The maximum percentage of your work-related expenses allowed as a credit for 2021 is 50 percent. The 2021 Instructions for Form 2441 and IRS Publication 503, Child and Dependent Care Expenses for 2021 both will contain a chart indicating the percentage of work-related expenses allowed as a credit at each income level. The IRS anticipates that the 2021 Instructions for Form 2441 and the 2021 Publication 503 will be available in January 2022.

Can this 50 percent amount of work-related expenses be reduced?

Yes. The amount of your adjusted gross income determines the percentage of your work-related expenses that you are allowed as a credit. For this purpose, your income is your “adjusted gross income” shown on your Form 1040, 1040-SR, or 1040-NR.

For 2021, the 50 percent amount begins to phase out if your adjusted gross income is more than $125,000 and completely phases out if your adjusted gross income is more than $438,000. For more information on the percentage applicable to your income level, refer to the 2021 Instructions for Form 2441 or IRS Publication 503, Child and Dependent Care Expenses for 2021.

For 2021, is there a limit on the amount of work-related expenses I can take into account in calculating the credit?

Yes. The maximum amount of work-related expenses you can account for purposes of the Child and Dependent Care Tax Credit is $8,000 if you have one child and $16,000 if you have two or more children. This means that the maximum total amount of the credit is $4,000 (50 percent of $8,000) if you have one qualifying person and $8,000 (50 percent of $16,000) if you have two or more qualifying persons.

I have two children. In 2021, I incurred more than $16,000 in work-related expenses for the care of one of them, and none for the other. Am I subject to the work-related expenses limitation for two children even though my expenses were only for the care of one child?

Because you have two or more children, you are subject to the higher $16,000 work-related expense limitation, regardless of how the expenses are allocated among your children.

For 2021, can I take the full Child and Dependent Care Tax Credit even if my credit exceeds the amount of taxes I owe?

Yes. For 2021, the credit is refundable for eligible taxpayers. This means that even if your credit exceeds the amount of federal income tax that you owe, you can still claim the full amount of your credit, and the amount of the credit in excess of your tax liability can be refunded to you.

What do I need to do for the credit to be refundable for 2021?

You must pay the work-related expenses incurred in 2021 by December 31, 2021, and meet the special residency requirements for the credit to be refundable for 2021.

What are the special residency requirements for the refundable portion of the credit?

To be eligible for the refundable portion of the credit for 2021, you (or your spouse in the case of a joint return) must have your main home in one of the 50 states or the District of Columbia for more than half of the tax year. Your main home can be any location where you regularly live. Your main home may be your house, apartment, mobile home, shelter, temporary lodging, or other location and does not need to be the same physical location throughout the taxable year. If you are temporarily away from your main home because of illness, education, business, vacation, or military service, you are generally treated as living in your main home during that time.

If I live in American Samoa, the Commonwealth of the Northern Mariana Islands, Guam, Puerto Rico, or the U.S. Virgin Islands in 2021, can I claim the credit if I’m otherwise eligible?

In many cases, the answer is yes. However, the credit must be claimed from your local territory tax agency and not from the IRS. Furthermore, special rules apply to these five U.S. territories. Contact your local territory tax agency for information about availability and your eligibility for the credit in 2021.

For more than half of 2021, I will live overseas, but not in one of the five U.S. territories. Can I claim the refundable credit on my 2021 tax return?

Generally, no. While you can claim the credit to offset your tax liability, the credit is refundable only if you (or your spouse in the case of a joint return) have your main home in one of the 50 states or the District of Columbia for more than half of the tax year. Your main home can be any location where you regularly live. Your main home may be your house, apartment, mobile home, shelter, temporary lodging, or other location and doesn’t need to be the same physical location or in the same state throughout the taxable year. If you are temporarily away from your main home because of illness, education, business, vacation, or military service, you are generally treated as living in your main home.

My main home is in one of the 50 states or the District of Columbia, and I am in the U.S. military and station outside the United States for an extended period. Am I treated as living in my main home during that time for purposes of the credit?

Yes. U.S. military personnel who are stationed outside the United States on extended active duty are considered to have their main home in one of the 50 states or the District of Columbia for purposes of qualifying for the refundable portion of the credit. For this purpose, “extended active duty” means any period of active duty pursuant to a call or order to active duty for a period in excess of 90 days or an indefinite period.

My spouse was out of work during the year. Can we still claim the Child and Dependent Care Tax Credit?

Maybe. Your spouse who is out of work during the year must be actively looking for employment, and the work-related expenses must be incurred so that you and your spouse can work or look for work. You (and your spouse in the case of a joint return) must have earned income to claim the credit. Earned income includes wages, salaries, tips, other taxable employee compensation, and net earnings from self-employment. A net loss from self-employment reduces earned income. Earned income also includes any strike benefits and disability pay you report as wages. Unemployment compensation is not included in earned income.

The amount of work-related expenses that can be taken into account in calculating the credit cannot exceed your earned income. If you are married and filing a joint return, your work-related expenses on your joint return are limited to the lesser of your or your spouse’s earned income.

What qualifies as a work-related expense?

A work-related expense is an amount you (or your spouse in the case of a joint return) pay for the care of a child, or for household services if at least part of the services is for the care of a child, in order for you to work or look for work. Your work can be for others or in your own business or partnership. It can be full- or part-time. It also includes actively looking for work. However, if you do not find a job and have no earned income for the year, you cannot take this credit.

Services that may qualify as work-related expenses include nanny-share arrangements, daycare, preschool, and day camp for your children, and the care can be provided either at your home or outside your home.

I pay my mother to watch my children during the day. Does this count as a work-related expense?

Yes, unless you can claim your mother as a dependent.

You can also count some work-related payments you make to other relatives, even if they live in your house. However, don’t count any amounts you pay to:

• A person you (or your spouse in the case of a joint return) can claim as a dependent;
• Your child who was under age 19 at the end of the year, even if the child isn’t your dependent;
• A person who was your spouse at any time during the year; or
• The parent of your qualifying person if your qualifying person also is your child and under age 13.

My child receives care outside my home so that I can work. Does this count as a work-related expense?

Maybe. To count as a work-related expense, the care must be for your child under the age of 13. Care provided outside the taxpayer’s home can be in a center or another person’s home. If the care is provided by a dependent care center, the center must comply with all state and local regulations that apply to centers. A dependent care center is a place that provides care for more than six persons (other than persons who live there) and receives a fee, payment, or grant for providing services for any of those persons, even if the center is not run for profit.

My child will be attending a week of overnight camp. Does that camp count as a work-related expense?

No. The cost of an overnight camp does not count as a work-related expense.

My child is enrolled in private kindergarten. Are the expenses to attend the private kindergarten work-related expenses?

No. Expenses to attend kindergarten or a higher-grade level are not expenses for care, and therefore are not work-related expenses.

I send my child to after-school care. Are these expenses work-related expenses?

Maybe. Expenses paid for before- or after-school care of a child in kindergarten or a higher-grade level are expenses for care, and therefore are work-related expenses, provided all other conditions are satisfied (for example, the expenses allow you to work or look for work).

GTM can help

Ready to pay your nanny on the books so you can take advantage of the enhanced Child and Dependent Care Tax Credit as well as the increased limits of Dependent Care FSAs? Give us a call at (800) 929-9213 to get started or for your complimentary, no-obligation consultation. A household employment expert will answer all your questions about hiring and employing a nanny to work in your home. You can also schedule time with us at your convenience.

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