Up to $5,000 of dependent care assistance may be excluded from an employee’s gross income. The employers contributions outlays are fully deductible. The employer does not have to fund the plan; instead they can pay as they go. However, as a practical matter this benefit may not make sense for a small business since nondiscrimination rules are intended to make sure that the plan does not favor owners. The plan prevents more than 25 percent of the amounts paid by the plan from benefiting owners (their spouses or dependents) who own more than 5 percent of the business.
The parents reduced their taxable income by $5,000 by excluding dependent care assistance from their gross income. Since the parents income was taxed at the 30% tax bracket, the income reduction may decrease their income taxes by $1,500 ($5,000 x 30%).
If you are in a combined (federal, self-employment, and state) tax bracket of 30%, you could reduce your taxes up to $300 for every $1,000 of income reduction by excluding dependent care assistance from your gross income.