FSA or Child-Care Credit?

published 13 October 2010

I have to make choices about my employee benefits during this year’s open-enrollment season. Is it better to pay for child-care expenses from a flexible spending account or to take the child-care tax credit?

If your employer offers a dependent-care flex plan, that’s usually a better deal than taking the child-care tax credit. Money you set aside in a flexible spending account is not only deducted from your gross salary before income taxes are calculated but also avoids the 7.65% Social Security and Medicare tax. So if you’re in the 15% income-tax bracket, contributing $5,000 to your flex plan (the maximum for most employers’ plans) would cut your federal income-tax bill by $1,133 next year. The benefits get better as your tax bracket rises, and you’ll save even more if your FSA contribution escapes state income taxes, too.

The dependent-care tax credit can help if you don’t have an FSA at work. It’s most valuable for people with very low incomes. To qualify, you must pay someone to watch a child who is younger than 13 so that you can 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 tax credit worth 20% to 35% of the cost of care, up to $3,000 for one child or up to $6,000 for two or more children. The higher your income, the lower the credit, bottoming out at 20% for those who earn $43,000 or more. The 20% credit would cut your tax bill by $1,000 if you pay $5,000 in child-care expenses for two kids.

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But there is a way to benefit from both options: If you have two or more children and your child-care expenses exceed $5,000 per year, you can set aside up to $5,000 in pretax money in your FSA, then claim the dependent-care credit for up to $1,000 in additional expenses.

For more information about the child-care tax credit, see FAQs on the Child Care Tax Credit.

As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.