While I'm becoming used to the $900+ monthly day care expense as part of my family's permanent cost structure, it's growingly important for me to understand how to drive the most tax benefits out of this line that represents more than 15% of my total household expenses.

Basically, there are two choices for me: claim a child care tax credit at year-end, or enroll in a dependent-care flexible spending account beforehand and allow automatica deduction in each of my paystub.

Child Care Tax Credit

Child care tax credit is defined in IRS Publication 503. In simple terms, it allows a precentage-based credit for up to $3,000 child care expense for families with one child, or $6,000 for families with two or more. To qualify for the credit, both parents need to work or actively seek for a job, and the available credit is based on the total child care spend (capped at $3,000 or $6,000) and income level. For my income level, I can claim 20% of the total spend as credit. The total benefit can be worth $3,000 * 20% = $600. Form 2441 is needed for claiming this credit.

Dependent Care Flexible Spending Account

Alternatively, I can enroll in dependent care flexible spending account during the benefit enrollment period in November. By doing this, I can deduct up to $5,000 in before-tax income and put it in a closedly managed flexible spending account. I can get reimbursed for any dependent care expenses from the account throughout the year and there is no hassle to fill up multiple tax forms to get tax benefits. The downside is the money is subject to use-it-or-lose-it rule: if I cannot use up the entire $5,000 fund, IRS confiscates what is left. As I'm at the 25% tax bracket, the potential tax benefit for me is $5,000 * 25% = $1,250. (There is an upside: I can expense more than I deduct from my salary year-to-date. In extreme examples, I can expense the $5,000 on Day One (of course with valid proof of expense) even if I only deduct $417 every month.)

Last year, I didn't consider the choice of flexible spending account -- at the time of open benefit enrollment, I didn't have much visibility whether or how much I will spend on day care. Therefore, this year I will go ahead and claim the child care tax credit -- with the $600 credit this can help to offload 20 days of my son's day care. (How expensive day care is!)

With the detailed study on both options, I'm very leaning toward the option of flexible spending for the coming year. Reasons being:

1) The $650 incremental tax benefit ($1,250 - $600)
2) More visibility of next year's day care expenses -- the next year's tuition will be around $850/month, and six months of day care expense will be enough to make sure I don't leave any money in the flexible spending account to the government.
3) The cash flow benefit is also attractive: I can essentially borrow money from the government to pay for day care in the first half of 2005.

The open enrollment at my company is sitll two months away, but unless I dig out other risks, I am pretty much sure there will be one more flexible spending account in the States next year.