Why flexible spending accounts win

Dear Tax Talk,
My wife and I both are planning to take advantage of our employer's Section 125 flexible spending accounts, both for unreimbursed medical expenses and child care costs. If the child care tax credit is $2,400 for 2003 and the flex plan limit is $5,000, isn't it a no-brainer to choose the flex plan as the most advantageous tax route to go if we know our child care expenses will exceed $5,000 next year? If we know that our out-of-pocket medical expenses will barely exceed the percentage threshold on our adjusted gross income for itemized deductions in 2004, doesn't it also make similar sense to max out our flexible spending account to reduce our adjusted gross income as well, particularly if we have a handle on our average annual medical expenses? Thanks. -- John

Dear John,
I like these no-brainer questions.

A flexible spending account is an employer-provided benefit that allows an employee to defer part of his salary on a pretax basis to pay certain allowed expenses. Included in these allowed expenses are child care costs and uninsured medical expenditures.

The child care credit is a tax credit equal to generally 20 percent of the amount that you spend on child care that isn't paid for out of a flexible spending account. If you spend $2,400 for one child to attend day care while you and your wife both work, you would get a tax reduction of $480. If you and your wife both work and, for example, your combined income is $150,000, your marginal tax rate is 28 percent. If you defer the same $2,400 into your FSA to pay for the child care expenses, your tax savings would be $672 (28 percent of $2,400). It therefore is a no-brainer that you're better off putting the child care money into the FSA.

Similarly, if you are barely getting over the threshold for deducting medical expenses, you would be ahead of the game if you put the same money into the FSA. For example, if you put $1,000 into an FSA to cover items not normally covered by insurance, such as prescription co-pays, eyewear and dental bills, you would save $280 in tax. Again, if your combined income is $150,000, you would have to exceed $11,250 (more than 7.5 percent of your adjusted gross income) in unreimbursed medical expenses to get even $1 off on your taxes. Another no-brainer.