The life of working parents is tough as it is. They have to excel at their workplace, keep up with work-related deadlines and bills at home, and, most importantly - take care of the kids. Fortunately, a nanny or a babysitter can help significantly in sharing the responsibilities at home and grant your young ones the attention that they truly deserve.
But did you know that such employment has tax implications as well? Let us introduce you to the Nanny Tax. It is a combination of payroll taxes that are withheld from a household employee - in a way, a tax deduction at the source. To elaborate further on these points, this article will talk about:
- What is a Nanny Tax?
- Nanny Tax Deduction Requirements
- Nanny Tax and Deductions: A Practical Illustration
- Can Employers Claim Tax Breaks for Nanny Tax Deduction?
- FAQs Around Nanny Tax Deduction
So, sit tight as we walk you through the nanny tax!
What is a Nanny Tax?
A Nanny Tax is a federal tax that is paid by people who employ nannies or babysitters as household employees. A household employee is someone who is hired to perform work that is controlled purely by the employer, and as such, covers employees like nannies, babysitters, butlers, gardeners, housekeepers, personal chefs or cooks, etc. They differ from independent contractors as the employer dictates the nature and amount of work, the disposal of this work, and the number of hours to be put into it.
The nanny tax allows eligible household employees to receive covered employee benefits and protections, such as Medicare, Social Security, and Unemployment benefits. It also grants them verifiable income as well as legal employment history, which may help them in gaining access to financial services such as loans, mortgages, and credit card facilities.
Nanny Tax Deduction Requirements
The nanny tax is subject to certain conditions, which can be summarized as follows:
- The household employer must have a valid Employer Identification Number (EIN) and a tax account with the IRS to fill out Form I-9. They must also supply Form W-2 to their household employee
- Nanny tax is applicable only for nannies or babysitters who are above the age of 18 years and are primarily engaged in the household employment profession
- The wages or net salary paid by the employer should exceed a certain amount as declared by the Internal Revenue Service (IRS) from time to time. The amount to be withheld, that is the nanny tax deduction, also changes accordingly
- Currently, the household employer will withhold nanny tax deduction at source for social security and Medicare at a rate of 15.3%, which is split into two equal parts of 7.65% contributed by the employer and the employee - as prescribed by the Federal Insurance Contributions Act (FICA)
- If the employer is paying cash wages of USD 1,000 or more per quarter for every employee, the unemployment tax liabilities on the employer, under the Federal Unemployment Tax Act (FUTA) is 6% on the annual cash wages up to USD 7,000
- Apart from these payroll taxes governed by FICA (declared in Form 1040), the employer may also have to withhold some amount as mandated by the state
- Employers will not have to pay the nanny tax in case the nannies or babysitters are hired through agencies as such employees are then on the agency’s payroll, making them the agency’s tax liability
- Nanny tax does not apply if the babysitter is the parent or spouse of the taxpayer
As of 2021, nanny tax is applicable for net pay exceeding USD 2,300 or more per employee. In 2020, this value was pegged at USD 2,200.
Nanny Tax and Deductions: A Practical Illustration
To better understand the concept of nanny tax deduction and the corresponding liabilities, let us take a look at four different cases.
Case 1: A Nanny Employed Regularly
Suppose a parent employs a nanny to take care of a child on weekdays and pays an annual salary of USD 40,000. The nanny tax deduction at source, in this case, would be:
FICA tax (employee contribution) @ 7.65% of USD 40,000:
= 7.65% of $40,000
= USD 3,060
FICA tax (employer contribution) @ 7.65% of USD 40,000:
= 7.65% of $40,000
= USD 3,060
FUTA tax (to be paid by employer) @ 6% of USD 40,000:
= 6% of first $7,000
= USD 420
Total Nanny Tax Deduction at Source:
= $3,060 + $3,060 + $420
Case 2: A Nanny Employed on Ad-Hoc Basis
Consider the case of an adult babysitter who is employed over the weekends and is paid USD 20. In the event that the babysitter is employed every weekend and that there are 52 weekends in a year, the net salary works out to be:
= $20 * 52
= $1,040 per annum
As the net pay is less than USD 2,300 as prescribed by the IRS, a nanny tax deduction will not be applicable in this case.
Case 3: Two Nannies Employed on Ad-Hoc Basis
Let us reconsider the case of the adult babysitter who is employed over the weekends. But in this case, there are two such babysitters, who are paid USD 50. Once again, working with the assumption that they have been employed every weekend and that there are 52 weekends in a year, the net salary to be paid to a single babysitter would be:
= $50 * 52
= $2,600 per annum
As the net pay is greater than the tax ceiling of USD 2,300, the nanny tax deduction will be:
FICA tax (employee contribution) @ 7.65% of USD 2,600:
= 7.65% of $2,600
= USD 198.90
FICA tax (employer contribution) @ 7.65% of USD 2,600:
= 7.65% of $2,600
= USD 198.90
FUTA tax (to be paid by employer) @ 6% of USD 2,600:
Not applicable as the employer would be paying USD 600 per employer per quarter.
Total Nanny Tax Deduction at Source:
= $198.90 + $198.90
= $397.80 per employee or $795.60 in total
Case 4: A Nanny Employed Through an Agency
Suppose you hire a nanny through an employment agency. As per the terms of the contract, you have to pay a net salary of USD 64,000 per year to the nanny for taking care of your child between 9:00 am to 5:00 pm on weekdays.
In this case, the nanny tax deduction on your part would be zero as the nanny is on the payrolls of the agency. As such, the agency is responsible for a nanny tax deduction and other tax liabilities.
Can Employers Claim Tax Breaks for Nanny Tax Deduction?
While the nanny tax may appear as a deterrent to parents, the IRS has attempted to lighten the tax liabilities on parents by granting tax breaks. In this case, you have the option to choose between the following schemes:
Dependent Care Account
The Dependent Care Account is a form of Flexible Spending Account (FSA). Under this scheme, parents can pay as much as USD 10,500 of their pretax earning contributions for all childcare-related expenses, which effectively covers the net pay to nannies as well. Thereafter, depending on the marginal tax rate, the FSA allows them to save as much as USD 4,800 (capping for 2021) in taxes.
Speak to your accounting or HR department to know more on how you can enroll for the Dependent Care Account.
Child or Dependent Care Tax Credit
While it does not technically offer “tax deduction,” the tax credit available at the year-end can restrict liabilities for those who do not have access to a Dependent Care Account. Employers can claim a tax credit of 20% to 30% of the qualifying childcare expenses with a ceiling of USD 3,000 in case of one dependent and USD 6,000 in case of two or more dependents. As such, the tax credit is approximately USD 600 to USD 900 in the case of a single child or USD 1,200 or USD 1,800 in the case of two or more children.
To benefit from this facility, employers will have to file Form 2441 with itemized care-related expenses in their income tax returns.
Advance Child Tax Credit Payments
The Child Tax Credit is the newest tax relief offered under the American Rescue Plan. Eligible households can receive monthly payments of USD 250 or USD 300 per child as advance payments of the credit. The remaining half can be claimed while filing the income tax return. These payments are disbursed automatically and employers do not have to file for them separately.
FAQs Around Nanny Tax Deduction
Now that you have a solid understanding of the nanny tax deduction let us address a few FAQs on the topic.
What are the employment tax exemptions on nanny tax?
The FICA tax is not applicable in the case of cash wages paid to babysitters who may be:
- A spouse
- Another child (below the age of 21) of the employer
- The employer’s parents (except those covered in exceptional cases such as when the parent cares for the child for more than four continuous weeks as the employer is under the age of 18, or suffers from a condition that excuses them from childcare, or is a widow)
- An employee younger than 18 years of age
Can I pay my nanny under the table?
While most household employee transactions take place in cash, know that paying your nanny under the table is illegal and can attract hefty penalties and interest, to the extent of being charged with tax fraud! Plus, to be eligible to claim tax breaks, you have to pay your nanny legally.
In short, do not pay your household employees under the table.
How can I maximize my tax savings despite the nanny tax deduction?
Claiming tax breaks under the Dependent Care Account is the best option for maximizing your savings, especially if you have a single child. By setting aside the full amount of USD 10,500, you can save between USD 3,700 to USD 4,800 in the given financial year.
However, if you have two or more children, you can claim the advantage of the Dependent Care Account and Dependent Care Tax Credit for a larger tax break. Utilize the complete USD 10,500 and adjust the remaining expenses (with a limit of USD 5,500) under the tax credit scheme. In this manner, you can save an additional USD 1,100 per year, which ups your savings to USD 4,800 to USD 5,900!
Do I have to pay my nanny overtime? Does that amount have tax implications?
As per federal laws, household employees are entitled to overtime pay for working over 40 hours in a 7-day workweek. Typically, the overtime rate is 1.5x the regular hourly wage. And since overtime is a component of the net salary, the proportionate nanny tax deduction will also apply.
Look up your local laws covering wage and hour rules to know more about this.
Being aware of your tax liabilities while engaging household employees can protect you from legal action by the IRS - even if the default is unintentional. Plus, you can write off these tax liabilities, which will reward you for compensating your employees legally. At the same time, it acts as a safety net in the interests of your employees and grants them social security. The nanny tax is one such piece in the larger picture. So stay educated and take necessary action.
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Let us condense everything that we have discussed so far into a TLDR as below:
- A nanny tax is a federal tax against the wages paid to household employees. These tax liabilities are governed by FICA and FUTA and the benchmark pay changes from time to time and is announced by the IRS for every financial year
- While it is named the Nanny Tax, the nanny tax deduction applies to all household employees, such as babysitters, gardeners, housekeepers, butlers, etc.
- Currently, the nanny tax deduction is applicable for net pay exceeding USD 2,300 or more per employee
- 15.3% of this (split into two equal halves) is set aside as contribution from the employer and employee for FICA. Similarly, 6% is set aside under FUTA (when wages are greater than USD 1,000 per quarter)
- Employers can claim tax breaks for nanny tax deduction under the Dependent Care Account, Dependent (or Child) Care Tax Credit, or Advance Child Tax Credit. To claim such benefits, you must pay your nanny legally
- The nanny tax deduction also covers payments made for overtime
The accounting tool at Deskera generates pay stubs that serve as proof for all childcare expenses. As such, you can keep track of your expenses and pay appropriate taxes and make claims against the same. Contact us to know more about how we make it happen!