For Parents Only: Navigating the ‘Nanny Tax’

One of the many things no one ever tells you about having kids is that they present some thorny issues at tax return time--especially for two-income households.

If you handle these tax issues right you’re likely to save hundreds of dollars. If you don’t you could get hit with penalties--and pay more tax, too.

The issues?

Nanny taxes, which are due for anyone paid more than $1,000 a year to watch your kids; child care credits, which give two-income couples a break on taxes; child care accounts, which help you save on taxes while paying day-care expenses; the earned income tax credit, and, in the event of divorce, the best way to divide tax exemptions for little dependents.

* Nanny taxes: Potentially the most serious tax gaffe parents make is failing to deal with the so-called Nanny tax.

This means the Social Security and Medicare taxes that must be paid for any domestic employee. It’s become known as the Nanny tax because live-in child care is probably the most common form of domestic help. Most gardeners and housekeepers are independent contractors, who require no special tax treatment.

The employer’s portion of the tax is 7.65% of the wages paid--6.2% for Social Security and 1.45% for Medicare. The worker is supposed to pay an equal amount through withholding. Since so many people ignore this tax, people who do comply complain that in effect, they must pay both halves to give the employee a competitive wage. Complying with the law does give the employee benefits, including Social Security credit and potential eligibility for unemployment pay.

Starting in 1995, reporting and paying taxes on a nanny’s wages is supposed to be vastly simplified, requiring little more than checking a box on the 1040 form and sending a check. This year, however, it still requires filling out a plethora of forms.

What do you have to file? You should have been filing quarterly forms with the IRS, called “Employers Quarterly Tax Return for Household Employees,” Form 942. If you pay a household employee more than $1,000 annually you also have to pay Federal Unemployment Tax and file Form 940.

Reporting and paying employment taxes to the state of California is far more complex because California treats household employers almost exactly the same as businesses.

That means you remit a series of taxes, including unemployment insurance, disability insurance, employment training taxes and, possibly, personal income taxes. Employers are required to pay the unemployment insurance and employment training tax portion. If they choose to, they can merely deduct the disability tax from the worker’s wages. Withholding California income taxes from a worker’s wages is voluntary, according to the Employment Development Department in Sacramento.

How much do you pay the state? It varies from year to year and employer to employer, depending on their “experience” with disability and unemployment, according to Suzanne Schroeder, an EDD spokeswoman. New household employers usually pay 3.5% of up to $7,000 in worker wages for unemployment insurance and employment training taxes, Schroeder adds. This year, it costs about another 1% of up to $31,767 in wages for disability. The state notifies employers of their tax rates each December.

The good news is, you’re not subject to the taxes until you pay more than $750 in a single calendar quarter. If you haven’t filed these federal and state forms each quarter you can do so at any time, but you may be subject to penalties and interest on taxes due.

The cost of the tax--and penalties for those who file late--could seem daunting, but realize that you may receive substantial tax benefits by putting your nanny on the books. In some cases the benefits will outweigh the cost.

There are two tax breaks for which you could qualify if you employ a nanny--or take your kids to child care or nursery school--so that both parents can work. One is the child care credit; the other involves employer-sponsored dependent care accounts.

* Child care credit: If you have children under 13 and you send them to day care or employ a nanny so that both mother and father--or, in the case of single parents, so that the custodial parent--can work, you can qualify for a tax credit of up to 30% of the first $4,800 in child care expenses.

The exact amount of the credit will depend on your income and how many children you have. To claim the credit you must fill out Form 2441, “Child and Dependent Care Expenses.” The form asks for information on the type of child care, how much you earn and how much you pay for child care.

The credit is then based on your income--the less you earn, the bigger percentage credit--and the smaller of your actual child care expenses, your income amount or $2,400 for each child, $4,800 total.

How much is it worth? Between 20% and 30% of the amount you spend, up to $4,800. It can range from $480 for one child in a family with gross income exceeding $28,000 to $1,440 for two children in a family earning less than $10,000.

For example, let’s say you earn $20,000 a year and spend $5,000 on care for two young children. Based on your income, your credit will amount to 25% of the allowable expenses. Since the maximum allowable expense is $4,800 for two or more children, the credit works out to $1,200 (25% times $4,800).

This credit amount is subtracted from any federal tax you owe.

* Dependent care accounts: Some large employers offer an employee benefit called dependent care accounts. These accounts allow a worker to set aside a portion of pretax income to cover child care expenses.

In some ways, these accounts work as 401(k) plans. The money comes out of your pay before taxes are deducted, so, as far as tax authorities are concerned, you’ve never earned it.

The money in the account is then paid directly from your employer. You can contribute up to $5,000 of your income to one of these accounts. That would save someone in the 31% tax bracket $1,550 in federal income taxes.

There’s one caveat: If you spend less on child care than the amount you put in the account, you lose the difference. A surplus cannot be carried from one year to the next. It cannot be refunded to the employee. And employees are generally not given the option of adjusting their contributions, except once a year. In short, don’t set aside more than you’re sure to use.

* Earned income tax credit: Low-income families--those with less than $25,296 in total income--are entitled to a credit, regardless of whether or not they pay for day care. A family with two children and $15,000 in total income could claim a credit worth $1,816, for example. To claim the EIC, parents must file a return and fill out a one-page form EIC.

* Divorce and taxes: Couples who divorce should know that they can negotiate who gets to claim the children as personal exemptions--that nets the chosen parent deductions of $2,450 a child in 1994. Only the custodial parent can claim the earned income tax credit or the child care credit.

The custodial parent is also the only one who may claim “head of household” filing status, which results in a higher standard deduction than is available to those who are simply single.

If support payments are going to pass from one parent to another, it’s also worth considering the tax implications of calling those payments alimony versus child support.

What’s the difference? Child support is neither deductible to the giver nor taxable to the receiver. Alimony is deductible to the giver and taxable to the receiver.

Anyone who is considering a divorce should consult a tax adviser. Structuring the deal correctly can result in both parents being better off--financially, at least.