Flexible Spending Account vs. Dependent-Care Credit

Is it better to pay for child-care expenses using a flexible spending account or to claim the dependent-care credit on my tax return?

Many people will have that question over the next few months, as they make decisions about their employee benefits for 2010. You may be allowed to set aside up to $5,000 in pretax money for the year in a flexible spending account for dependent-care expenses. Or you could claim those expenses for the dependent-care credit when you file your 2010 tax return. But you can’t use the same expenses for both tax breaks.

Most families who have access to a dependent-care flexible spending account at work would be better off running their child-care expenses through the FSA.

Money you set aside in a flexible spending account is not only subtracted from your paycheck before income taxes are calculated, but it also avoids the 7.65% Social Security and Medicare tax. So if you’re in the 15% income-tax bracket, you won’t have to pay the 15% federal tax or the 7.65% Social Security tax, which means that you’ll avoid paying a total of 22.65% in taxes on that money. In that case, contributing the maximum $5,000 to your dependent-care flex plan cuts your tax bill by $1,133. The benefits get even better as your tax bracket rises. If you’re in the 25% bracket, for example, you’ll end up saving 32.65% in taxes on the money you contribute to the FSA — and lowering your tax bill by $1,633. You’ll save even more if your FSA contribution escapes state income taxes.

See our How Much Should I Put in My Flexible Spending Account? calculator to help figure out how much your contributions will lower your tax bill. (You can also use this calculator to figure out how much money to set aside in your FSA for medical expenses, which have separate contribution limits.)

Also keep in mind that you generally must use the money in the flexible spending account by December 31 (or in some cases by March 15 of the following year) or else you will lose it.

The dependent-care credit, however, can help lower your tax bill if you don’t have a flexible spending account at work, and it’s most valuable for people with very low incomes.

To qualify for the dependent-care credit, you must pay someone to watch your child, who has to be younger than 13, while you work or look for work. Both spouses must have earnings from a job or self-employment, unless one is a full-time student. You can take a 20% to 35% credit for up to $3,000 in child-care expenses for one child (the higher your income, the lower the percentage) or up to $6,000 in child-care expenses for two or more children. That means the credit ranges from $600 to $1,050 if you have one child, or $1,200 to $2,100 if you have two or more children. And remember that a tax credit lowers your tax liability dollar for dollar.

But you’ll qualify for that maximum credit only if you have a very low income – currently less than $15,000. If your income is more than $43,000, you’ll qualify for the 20% break, which means that if you have $5,000 in child-care expenses, you’d get a tax break of only $1,000.

See A Tax Break for Sending the Kids to Camp and Five Things to Know About the Child-Care Tax Credit for more information.

If you have two or more children and child-care expenses exceeding $5,000, you might be able to benefit from both the FSA and the dependent-care credit. You can set aside up to $5,000 in pretax money in your FSA, and claim the dependent-care credit for up to $1,000 in additional expenses.

You can sign up for the FSA during open-enrollment season, then keep track of your child-care expenses throughout the year and possibly qualify for the credit on the extra $1,000 in expenses when you file your 2010 tax return. If you qualify for the 20% credit on that $1,000, you’ll save an extra $200 on your taxes.