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Spending accounts vs. child care credit


Dear Tax Talk,
Our infant daughter will be entering day care this month and we are trying to figure out which makes more sense, to set aside money in a flexible savings account or to take the child and dependent care credit? Is there a way to take advantage of both?

My husband and I both work; we make approximately $60,000 and our marginal tax bracket is 15 percent. After reading other answers posted on Tax Talk, we figure that because our tax bracket is less than 20 percent, we are probably better off taking the tax credit. However, as I understand it, we can only count up to $3,000 toward the tax credit (20 percent of $3,000 will be $600). But we will be spending about $6,500 a year.

Does it make sense to put the difference ($3,500) into a flexible spending account? In other words, are we allowed take advantage of both an FSA and the tax credit if our expenses exceed $3,000? -- Christy

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Dear Christy,
What one hand gives, the other takes away. An employer that offers a flexible spending account (FSA) can allow you to defer up to $5,000 of your compensation to cover dependent-care expenses. An employee contributing to an FSA saves income tax on the amount deferred to the account. In your case, you could save up to $750 in taxes.

A credit is also allowed on your Form 1040 for dependent-care expenses. The credit is claimed on Form 2441 and is limited to up to $3,000 in care expenses for one child and $6,000 for more than one. For taxpayers with adjusted gross income of more than $43,000, the credit is 20 percent of the $3,000 or $6,000 in expenses; the credit percentage is higher at lower adjusted gross income levels.

Here comes the hand that takes away. The $3,000 and $6,000 limits are reduced by the amount paid from an FSA. In your case if you put only $3,000 into the FSA, you would not receive the 20 percent credit on your 1040 since you would reduce the $3,000 limit by that amount. Since your credit savings would only be $600, you're slightly better off using the FSA to pay for up to $5,000 in expenses and saving $750 (15 percent of $5,000) in taxes.

-- Posted: Aug. 11, 2004




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