A must-read from Morningstar for anyone with kids in daycare, with a nanny, etc.

http://news.morningstar.com/articlenet/article.aspx?id=539497

In particular, there are some great examples of how much less is going to be paid in taxes one way vs. the other.

The dependent care FSA lets one put away money (through one’s employer, only) on a pre-tax basis — pre-income-tax as well as pre-payroll (SS, Medicare) tax — and use that money to pay for child care costs. Since this saves you on taxes you’d normally pay at your marginal rate, and our progressive tax system means your rate is higher the more you earn, the pre-tax FSA is more valuable the more you earn.  Up to $5000 may be put aside into a dependent care FSA account, though it is subject to the use-it-or-lose-it rules, so don’t put aside more than you know you are going to use.

The Federal tax credit for child care lowers your federal taxes (it’s a credit not a deduction) by anywhere between 35% and 20% of up to $3000 for one child or $6000 for two or more. The percentage declines as your AGI goes up, so this is actually more valuable the less you make.

Morningstar shows examples at various income rates and offers the rule of thumb that if you are in the 25% bracket (starts at $34,500 single and $69,000 joint), you are probably best off with the FSA, though it is possible to max out your FSA and still have room to use the tax credit as well, especially if you have more than one qualifying dependent.

For more information about the Federal tax credit, see IRS pub 503.  (PDF may be found here:  http://www.irs.gov/pub/irs-pdf/p503.pdf

The IRS also has a “10 things you should know about the Child and Dependent Care Tax Credit” page here:  http://www.irs.gov/newsroom/article/0,,id=106189,00.html

Remember, too, that there are other tax benefits that come with your kids, from potentially qualifying for the Earn-Income Tax Credit and the Child Tax Credit (separate from the dependent care credit noted above – see http://www.irs.gov/newsroom/article/0,,id=106182,00.html — up to $1000 credit per child) as well as getting additional exemptions for dependents.  Kids can add a lot to our family expenses – so make sure to take advantage of all the benefits in the tax code to help reduce those costs.