The Nanny Tax. How Does it Work?

Parents working from home. Kids learning at home. Help needed! So, you hired a nanny to reduce the pandemic chaos. What a relief! But did you think about the tax issues involved? With tax deadlines approaching, now’s the time to figure it out.

The pandemic turned childcare plans upside down more than a few times. Many families had to rethink their childcare arrangements and quickly make adjustments. In some cases, part of the solution may have involved a nanny. In that survival mindset, taxes probably weren’t front of mind, but now that tax time is upon us, families and nannies may be wondering if they made the right decisions regarding taxes.

Who Exactly Are We Talking About?

When an individual works in someone’s home and has specific tasks and responsibilities dictated by the homeowner, the IRS considers that individual a household employee. This designation covers a wide range of roles, including, but not limited to, nannies/babysitters, health aides, caretakers, house cleaners, and yard workers.

When the definition of household employee is met and the family/employer pays the employee more than $2,300 in 2021 ($2,200 in 2020), the employer should be withholding and paying Social Security and Medicare tax on behalf of the employee.

What about family members? If an older sibling is under age 21 and watching their younger siblings, employment taxes won’t apply. The same goes for grandparents and other “employees” under the age of 18.

What Taxes Are We Talking About?

Employers are required to collect and pay Social Security and Medicare tax, also known as FICA. This mandate applies to traditional corporate employers as well as families who meet the definition of an employer.

The employer’s portion of FICA tax is 6.2% for Social Security and 1.45% for Medicare, for a total of 7.65%. That’s just what the employer is responsible for. The employee must also pay their share, which is another 7.65%. However, if the employer fails to withhold the employee portion from their wages, the employer is responsible for the entire 15.3%.

If the employer pays more than $1,000 in any quarter of the calendar year, the employer is also responsible for paying a 6% Federal Unemployment Tax (FUTA) on the first $7,000 in wages. Each state has laws that determine if state unemployment insurance or disability and workers’ compensation are also required. The FUTA tax rate can be reduced to .6% if state unemployment taxes apply.

Who Creates the Tax Forms?

The first step is for the family/employer to apply for an employer identification number (EIN). This may sound intimidating, but it can be done in less than 10 minutes at www.irs.gov.

When it comes to generating the appropriate tax forms, reporting withholding, and any other required information, many families purchase software designed specifically for the purpose of paying household employees. Another option is to hire a bookkeeper or an accountant to help with filings and ensuring everyone is compliant.

The aforementioned takes care of the employee’s required tax filings. What about the employer's required filings? Employers need to file a Schedule H when completing their individual 1040. This form covers FICA, FUTA, and other taxes that might have been withheld.

Can The Family/Employer Offset Their Tax Liabilities?

Families with children may have a few options to reduce their own tax bill depending on their situation and regardless of whether they hire a nanny or utilize a childcare facility.

Some employers offer a Dependent Care Flexible Spending Account as part of their benefit offerings. Employees can contribute up to $5,000 of their pretax earnings to the account to use for qualified dependent care expenses. These dollars can reimburse the family for their nanny’s pay.

Another possible tax benefit is the Child Care Tax Credit. This credit allows the taxpayer to claim between 20% and 35% of childcare expenses based on income. The credit can be up to $3,000 for one child or up to $6,000 for two or more children. Again, a nanny’s pay qualifies as a childcare expense for purposes of receiving the tax credit.

It’s possible that a family can utilize a Dependent Care FSA and receive the Child Care Tax Credit, but not for the same expenses.

Cash Isn’t Always King

It’s not uncommon for families to pay their childcare providers in cash, but as outlined above, there are several legal requirements that must be adhered to. Paying a nanny under the table puts the employer and the employee at risk.

If the IRS gets involved, penalties and back taxes will almost certainly be applied. A nanny could also choose to file for unemployment if his/her work with a family ends (even if everyone is on good terms). That claim will trigger to the state unemployment office that the applicable taxes were not paid.

Beyond providing some peace of mind, paying a nanny legally also helps him/her to build credits with Social Security and Medicare that will be beneficial down the road.

Bottom line: It’s worth taking the time to structure household employee arrangements at the beginning of an engagement so everyone involved is protected from day one.

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