When families start the nanny hiring process, there are lots of questions about the cost. Are there tax breaks available? Which one should I use? Are there income restrictions? How much should I budget?
Here’s what you need to know.
All families who pay their employee legally are entitled to at least one tax break, regardless of their income level. The only restrictions are that the children under care must be under age 13 and both parents must pass the “work-related test,” meaning each is employed, looking for employment or a full-time student.
For many families, the tax savings offset most of the employer tax cost. For some, the savings can even exceed the cost of their employer taxes (yes, it’s possible to come out ahead financially).
Here are the two childcare tax breaks:
1) Dependent Care Flexible Spending Account (FSA). Many companies offer their employees the option to contribute up to $5,000 of their pre-tax earnings every year to an FSA. Because paying nanny taxes qualifies as a childcare expense, you can take advantage of paying these expenses tax-free. Depending on your marginal tax rate, this tax break can save as much as $2,300 per year. If you think your company offers an FSA program, we recommend that you talk to the benefits manager about enrollment. Open enrollment usually occurs in the fall for the subsequent tax year, but there are exceptions for life-changing events such as the birth of a child that may allow you to enroll in this tax year.
2) Child and Dependent Care Tax Credit. Household employers are entitled to a 20% tax credit on childcare expenses of up to $3,000 for one dependent ($600 savings) or up to $6,000 for two or more dependents ($1,200 savings). You can claim this tax credit by completing IRS Form 2441 as part of your personal income tax return at year-end.
If you only have one dependent under age 13, you’ll have to choose between the two tax breaks. For most families the FSA is the best option.
If you have two or more dependents under age 13, you can take advantage of both tax breaks if your childcare expenses were greater than your FSA contribution. Excess expenses (up to the $6,000 expense limit) may be applied to the Child and Dependent Care Tax Credit on Form 2441.
To calculate your employer budget, visit our free Nanny Tax Calculator. With these significant breaks, most families find that paying a nanny legally is not only the right thing to do, it’s also the wise thing to do.