by Robert Flach

Created on: October 27, 2007

For many employers the fall is time for "open enrollment" for various employee benefits, including dependent care and health care "flexible spending accounts" (FSA). If your employer offers an FSA you should consider participating you can realize substantial tax savings from such a plan.

Participants in an employer-sponsored dependent care and health care FSA can set aside a specific dollar amount of their salary each year to pay for qualifying child-care or medical expenses during the year. The maximum amount that can be set aside for a dependent care plan is $5,000. There is no statutory maximum for a medical expense FSA, but most employers will limit employee contributions.

Monies set aside in a flexible spending account are considered "pre-tax" for both federal income tax and FICA (Social Security and Medicare) tax purposes. If your annual salary is $50,000 and you set aside, and spend, $5,000 in an FSA, the federal wages reported in Box 1 on your Form W-2, as well as the Social Security and Medicare wages, will be $45,000. If you are in the 25% bracket, this $5,000 will save you $1,633 in federal income and FICA taxes.

A pre-tax contribution to a dependent care FSA will generally provide a greater tax benefit than claiming the Child and Dependent Care Credit especially for those in the 25% and higher brackets. The maximum credit allowed for such a taxpayer is $600 for one qualifying child or $1,200 for more than one qualifying child.

Medical expenses are deductible as an Itemized Deduction on Schedule A only to the extent that they exceed 71/2% of AGI. Medical expenses paid through a pre-tax health care FSA are fully deductible from gross income.

The savings does not end there. Employee contributions to an FSA will reduce Adjusted Gross Income and may therefore increase deductions and credits that are affected by AGI (such as medical and miscellaneous expenses on Schedule A). Plus many states also treat FSA contributions as "pre-tax", so you may save state income tax as well. Unfortunately, New Jersey does not treat contributions to either type of FSA as being "pre-tax".

An FSA is a "use it or lose it" plan. If the amount of qualifying child-care or medical expenses paid by an employee-participant during the year is less than the amount that has been set aside in the plan the employee loses the excess. For example, if Mary Mom has set aside $5,000 of her salary in her employer's dependent care FSA for 2007, but pays only $4,000 in qualifying child care expenses

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