The value of child and dependent care assistance provided by an employer under a written, nondiscriminatory plan is not taxable up to $5,000, or $2,500 for a married couple filing separate tax returns. The $5,000 / $2,500 limits also apply if a taxpayer makes pre-tax salary deferrals to a flexible spending account for child and dependent care expenses.
The tax-deductible amount for child and dependent care expenses provided by an employer cannot exceed your earned income (salaries and wages). For example, a taxpayer who earns $4,000 can only deduct $4,000 for child and dependent care expenses. If you are married and your spouse does not work (unless they are a full-time student) then the entire amount is considered taxable income.
The expenses must qualify for the child and dependent care credit in order to be excluded from your income. You must give your employer a record of the care provider’s name, address, and tax identification number (this information must also be provided to the IRS on your tax return).
The tax-free portion of child and dependent care expenses reduces the amount of expenses eligible for the child and dependent care credit. If you are claiming a credit for child and dependent care, the benefits must be reported on Part III of Form 2441. Part III of Form 2441 is where you determine the tax-free and taxable portions of the employer-provided child and dependent care benefits.
The total amount of child and dependent care benefits is shown in Box 10 of Form W-2. Any benefits over $5,000 will also be included in Box 1 of Form W-2 as taxable wages, Box 3 of Form W-2 as Social Security wages, and Box 5 of Form W-2 as Medicare wages.