(MONEY Magazine) – Imagine this. You get a note one day from the Internal Revenue Service saying the agency feels bad that it's been taxing you on money you need to pay for such basic expenses as health insurance deductibles, routine physicals and day care for your child. So if you'll just tell your employer what you spend on these necessities, that amount of your salary will now be tax-free. There's a P.S. from Social Security: that agency agrees and won't tax you either. Too good to be anything more than a daydream? Here's the amazing part. You may in fact already have gotten such a proposal -- and if you haven't yet, you will soon. The offer comes in the form of a flexible-spending account (FSA), and it's one of the fastest-growing benefits provided by companies for their workers. FSAs are currently available at about a third of major corporations, and as many as half of all companies are expected to provide such accounts within the next few years. If your employer is among those already offering FSAs, you'll have to hurry to decide whether to take the company up on the offer. Although FSAs can run on any 12-month schedule your employer chooses, most follow the calendar year. Between now and Jan. 1, chances are you'll have to decide whether such an account makes sense for you and your family. Unlike most tax breaks, an FSA is as good as it sounds -- maybe even better. You authorize your employer to set aside a pool of untaxed money in special accounts earmarked for health-care costs not covered under other benefits, or for day care for a child or a disabled dependent. Although about a quarter of the companies that offer FSAs furnish some or all of the cash for them, the accounts are mostly funded through deductions from your paycheck made in equal installments over a year. Your contribution is exempt from federal income and Social Security taxes as well as most state and local taxes. During the course of the year, you submit copies of your bills for eligible expenses to the company or an outside administrator and are reimbursed, usually in a few weeks. Your potential savings: up to nearly $2,500 on dependent care and possibly more on health costs. What's the hitch? Just one: you must figure out how much you will need in your accounts in the coming year and commit to that amount. At the end of the 12-month period, you forfeit any funds left unspent in your account. In reality, however, few FSA users actually end up losing any money -- less than 7% of health-care contributions and just 1% of dependent-care allocations were forfeited last year. Still, that small requirement and potential penalty are off-putting enough to make FSAs probably the most underused benefit on the books. Indeed, fewer than 25% of employees whose companies offer FSAs take advantage of them. ''It really doesn't make sense,'' says Steven Fein, a benefits adviser with Towers Perrin Forster & Crosby, a New York City consulting firm. ''Most people could save a bundle of money with these accounts, yet they just don't bother.'' Don't repeat their mistake. Setting up and managing a flexible-spending account is less complicated than many employees fear. What follows is a closer look at the two types of accounts to help you decide the exact amount you need to contribute and how much you can expect to save on your taxes as a result. The health-care FSA. No matter how comprehensive the medical insurance your employer provides, chances are you still end up shelling out a significant amount. The average American spends about $500 out of pocket for health care every year. By law you are entitled to deduct these expenses on your tax return only if your total medical outlay exceeds 7 1/2% of your adjusted gross income -- a barrier that almost no families cross. But with an FSA, you can get a tax break on any amount you spend, however small, up to an annual limit set by the employer, of around $4,000. The expenses approved for reimbursement through your FSA are the same as those eligible for the write-off on your 1040. Topping the list are nearly all payments that you are required to make under your company's health plan, such as your annual deductibles and your share of expenses partially covered by the policy, including bills for orthodontia and psychotherapy as well as regular medical and dental charges. You may also draw on your FSA to pay many expenses not covered under company plans, such as eyeglasses, hearing aids and prescription drugs. Elective procedures that are never covered by your employer, such as hair transplants, electrolysis, sterilization and even facelifts, similarly qualify for an FSA reimbursement. Although many of these health-care costs are hard to predict -- and impossible with, say, an appendectomy or ski accident -- some advance planning is needed to calculate your FSA contribution for the coming year. The idea is to figure out the expenditures you can control (including any elective procedures you may schedule) and make an educated guess about the rest. That's the approach taken by Ellen and Gary Kohls of Milwaukee, who have funded health-care FSAs since their introduction five years ago by the couple's employer, Effective Management Systems, a computer software design firm. The couple's 1989 combined accounts of $950 include $500 of their own money and a $450 contribution from their employer. In past years, their FSAs have paid for braces for Gary, glasses for Ellen and school physicals for their son Mike, now 18. ''We try to figure out who's going to need what next year and then factor in the variables, like what dental work we might need,'' says Ellen. ''So far, we've never been more than $100 off, and we've probably saved $3,500 in taxes.'' If you're having trouble projecting your health-care expenses for the coming months, review your medical bills from the past year. Exclude any amounts paid by insurance as well as extraordinary expenses that are not likely to be repeated. The balance represents a rough estimate of your regular out-of- pocket expenses. If you're concerned that your bills may be lower in 1990 than in previous years, cut the total by 20% or so to be safe. The dependent-care account. By law you are allowed to set aside as much as $5,000 a year in an FSA to pay for certain day-care costs for a child under 13 or a dependent adult living with you. The standards of eligibility are roughly the same as for the dependent-care tax credit that you can claim on your 1040. As long as you incur the expenses in order to allow you to work, most forms of day care qualify, including sitters at home, child-care centers, and nursery schools, as well as day care for the disabled and the elderly. The major exception: sitters who are paid off the books. You cannot both take the tax credit and draw upon an FSA to pay for the same expenses. If your adjusted gross income is more than $24,000 a year, you will almost always be better off paying your day-care bills through an FSA. The reason is that the tax credit is far less generous -- allowable expenses are capped at $2,400 for one dependent and $4,800 for two or more -- and the credit dwindles from 30% of your expenses to 20% as your income approaches $28,000. The FSA, by contrast, allows you to claim the maximum $5,000 even if you have only one dependent, and the higher your income, the more the exemption from taxes is worth to you. Unlike the health-care FSA, calculating how much to set aside in your dependent-care account is fairly simple -- particularly if your work schedule is easy to predict and you'll be employing the same day-care provider as you have in the past. Just add up the weekly price of care, making sure to factor in Social Security and other taxes you pay for a self-employed sitter plus any expected fee increases. At the same time, subtract for holidays and vacations. Deborah Stevenson of Portland, Ore. puts $230 into her account each month at American Staff Management, an employee leasing firm, to pay for day care for her five-year-old Cassandra. ''I checked the 1989 holiday and fee schedule with Cassie's day-care center last year so I'm right on target,'' says Stevenson, the company president. ''The center even agreed to submit the bills directly for reimbursement, without going through me. It's worked out perfectly.''

Once you've committed to a certain amount for your FSA -- either health- or dependent-care -- for the coming year, you can change your contribution only under a few limited circumstances. For instance, if you marry, divorce or have a child, or if your spouse loses his job, you can usually increase, decrease or stop your deductions -- although the money put aside up to that point must remain in your FSA. If you find yourself with time running out and money left unspent, what can you do? You can accelerate expenses scheduled for the following year, such as teeth cleanings or medical screenings like Pap tests or mammographies. You can stock up on supplies of regularly used drugs or equipment, such as insulin or hypodermic needles, or buy spare contact lenses or glasses. You can even double up on your psychotherapy sessions. But what if your problem isn't with the FSA you have but the one you don't have? That is, how can you convince your employer to offer these accounts? Try lobbying with the head of your human resources department. You may be more influential than you think. Last year, companies cited ''meeting workers' needs'' as their main reason for including FSAs in their benefits package. And not far behind: ''competitive pressure from other companies.''

BOX: How much should you contribute to your health-care FSA?

( Use this worksheet to estimate the health-care costs you are likely to face next year. To figure out your tax savings by paying these bills through an FSA, multiply your costs by your combined federal, state and local tax bracket (dividing the total amount of taxes deducted from your paycheck by your gross salary should roughly equal your combined bracket).

Annual deductibles for your family under your company medical and dental plans $

Co-payments (your share of expenses partly covered under company plan) $

-- Medical (typically 20% of the plan's allowable charges, plus 100% of amounts above this limit) $

-- Dental (typically 25% to 40% of allowable charges, plus 100% of costs exceeding this limit) $

Routine physical examinations $

Hearing care (including screening and hearing aids) $

Psychotherapy (including deductibles, co-payments and 100% of charges above the limit allowed by the plan) $

Vision (including eye exams, glasses and contact lenses) $

Orthodontia $

Other planned uncovered expenses (e.g., cosmetic surgery) $

1. TOTAL ESTIMATED HEALTH-CARE EXPENSES $

2. Your combined federal, state and local tax bracket %

YOUR ANNUAL TAX SAVINGS (line 1 times line 2) $

BOX: How much should you contribute to your dependent-care FSA?

Use this worksheet to estimate the amount you'll spend on day care next year and the taxes you can save by paying those expenses through an FSA.

Payments to a day-care center or agency $ Payments to an individual sitter $ Social Security and other taxes paid on behalf of a self-employed individual $ 1. TOTAL ESTIMATED DAY-CARE EXPENSES

2. Combined federal, state and local tax bracket %

YOUR ANNUAL TAX SAVINGS (line 1 times line 2) $