Comparison with the Tax Credit

Child care expenses for which you're paid or reimbursed under an employer's plan cannot be used again in determining whether you're eligible for the tax credit for child and dependent care. Obviously, if your employer doesn't offer any assistance, the tax credit is your only choice.

One difference between the two types of tax breaks is especially important for those with only one child or qualifying individual. Under the tax credit, you are only allowed to count the first $3,000 you spend for care of that individual ($6,000 for more than one individual). However, under the employer assistance plan, you may count up to $5,000, whether it's spent on one person or several.

The second factor to consider is your tax bracket. If you're in the 25 percent bracket, your federal tax "discount" for using the employer's plan will probably equal 32.65 percent of your allowable expenses (25 percent federal income tax + 7.65 percent FICA tax), unless your salary is over the Social Security ceiling. Even if it is, you'll still have a 26.45 percent discount (25 percent income tax + 1.45 percent Medicare tax) or a 26.54 percent discount (25 percent income tax + 1.45 percent Medicare tax + 0.09 percent Medicare surtax). However, families with adjusted gross income higher than $43,000 who use the tax credit will get a credit of only 20 percent of their allowable expenses.

A third factor to consider is the alternative minimum tax (AMT). Ordinarily, if you are subject to the AMT, your tax credit may be limited or potentially extinguished. However, employer-paid dependent care assistance is subtracted from your adjusted gross income before the AMT is calculated, so it will not be affected by the AMT calculation (and in fact can help you to avoid the AMT by keeping your AGI lower).

Reduced retirement benefits. One more factor to consider when deciding whether to take advantage of your employer's plan or to go for the tax credit is the Social Security angle.

Because you don't pay Social Security tax on the amounts that are withheld from your paycheck to fund your dependent care reimbursement account, these amounts aren't counted as part of your salary when you eventually retire and collect Social Security benefits. So, you might qualify for a slightly lower benefit at retirement because of the dependent care benefits you're getting now.

In most cases, this benefit reduction would be slight, particularly if you have a long working career but receive dependent care benefits for only a few of those years. Moreover, it's generally better to save tax dollars now, rather than to pay more tax now in the hope of getting a larger retirement benefit 20 or 40 years down the road. It's quite likely that the rules for computing Social Security benefits will have changed by then, anyway.