Nanny Tax

The nanny tax is the set of federal employment taxes a household owes when it employs someone to do work in or around its home. The IRS name for it is household employment taxes, the guide is Publication 926, "Household Employer's Tax Guide," and the return is Schedule H (Form 1040), titled "Household Employment Taxes (For Social Security, Medicare, Withheld Income, and Federal Unemployment (FUTA) Taxes)." The popular name stuck because childcare is the commonest trigger, but the rules do not mention nannies and the same obligations attach to a housekeeper, a home health aide, a private nurse, a cook, a driver or a yard worker.

Two things distinguish it from ordinary payroll. The household is the employer, with all the filing duties that implies, including an employer identification number and a Form W-2 for the worker. And the taxes are settled on the family's own income tax return rather than through the quarterly employment tax returns a business files.

Employee or contractor is not a choice the parties make. Publication 926 states the test directly: "The worker is your employee if you can control not only what work is done, but how it is done." Full time or part time does not matter, nor does hiring through an agency, nor whether pay is hourly, weekly or by the job. The mirror image is equally clear. A worker who controls how the work is done, provides their own tools and offers services to the public is self-employed. A childcare provider who works in their own home is generally not your employee. And where an agency both provides the worker and controls the work, the worker is the agency's employee, not yours.

Not everything done in a home is household work. The publication draws the line at the nature of the service rather than the location: work performed as a private secretary, tutor or librarian is not household work even when it happens in your house.

Several relationships are excluded outright. Under section 3121(b)(3), wages you pay your spouse, your own child under 21, or your parent are generally outside Social Security and Medicare tax, with a narrow exception that can pull a parent back in where the employer is a widowed or divorced parent with a young child at home. Section 3121(b)(21) separately excludes domestic service by anyone under 18 whose principal occupation is not household work, which is what takes the neighborhood teenager who babysits on Saturdays out of the system. Wages excluded from these payroll taxes are still the worker's taxable income.

The two wage tests are different tests, and missing that is the commonest error. Social Security and Medicare tax attach once you pay a single household employee cash wages of at least $3,000 in the year. Section 3121(x) reindexes that figure annually against the national average wage index and rounds it to the next lowest multiple of $100, and it is tested per employee rather than across the household. Federal unemployment tax runs on an entirely separate quarterly test: section 3306(a)(3) makes you an employer if you paid $1,000 or more in cash wages for household service in any calendar quarter of the current or preceding year, counted across all your household employees rather than one at a time. A family can therefore owe one of these taxes and not the other.

The worker's side of the ledger is the part paying cash quietly destroys. Reported wages build the Social Security and Medicare earnings record that future retirement, disability and survivor benefits are calculated from, and state unemployment coverage usually follows from the same reporting. A household worker paid off the books has none of it, and no pay stub to show a landlord or a lender.

A household employer gets an employer identification number, verifies the worker's authorization to work, and then withholds the employee's 7.65 percent share of Social Security and Medicare tax from each payment while adding a matching 7.65 percent from its own funds. Federal income tax withholding is optional, and the family may agree to it if the employee asks. Federal unemployment tax is the employer's alone at 6.0 percent of the first $7,000 of each employee's cash wages, reduced by a credit of up to 5.4 percent for state unemployment contributions paid on time, which brings the usual net rate to 0.6 percent. It is never withheld from the worker.

Nothing is filed quarterly. In January the family gives the employee copies of Form W-2 and sends Copy A with Form W-3 to the Social Security Administration. In the spring, Schedule H is attached to the family's Form 1040 and the total is added to their income tax. Because that produces a lump sum at filing, the IRS suggests covering it during the year, either by increasing withholding at your own job or by making estimated tax payments.

A hypothetical example. Alma pays a home health aide $600 a month, or $7,200 for the year, which clears the annual Social Security and Medicare wage test. She withholds the employee share of 7.65 percent, which is $550.80, and owes a matching $550.80 herself. Her quarterly wages are $1,800, above the $1,000 federal unemployment threshold, so unemployment tax applies to the first $7,000 of cash wages at the usual net rate of 0.6 percent, which is $42. Her own cost is $550.80 plus $42, or $592.80, and the aide's take-home pay is $7,200 less $550.80. If Alma chooses to pay the employee's share herself instead of withholding it, section 3121(a)(6)(A) keeps that payment out of wages for Social Security, Medicare and unemployment purposes, though it is still income to the worker.

Paying household employment taxes is a legal obligation rather than an option, so the honest comparison is between complying and not.

What complying buys

• The worker accumulates Social Security and Medicare earnings credits and, in most states, unemployment coverage.
• The family has a documented, lawful employment relationship, which matters if the arrangement ever ends badly or if a workers' compensation claim arises.
• Wages properly reported can support a dependent care flexible spending account election or the child and dependent care credit, both of which require identifying the care provider.
• It removes an open-ended exposure: unpaid employment taxes carry interest and penalties and have no expiry while returns go unfiled.

What it costs

• The employer's share is a real addition to the cost of care, roughly 8 percent on top of wages before any state taxes.
• It creates paperwork a household is not set up for: an employer identification number, year-end wage statements, a Schedule H, and often a state registration as well.
• The bill lands as a lump sum with the income tax return unless the family plans ahead, and nothing about the payroll process reminds them.
• State rules are separate and vary, including unemployment insurance registration, wage notices and, in some states, workers' compensation.