Should You Be Paying the 'Nanny Tax'? 3 Factors to Consider

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Whether it's for child care, lawn work or a host of other chores, millions of Americans hire people and bring them into their homes to do necessary work. But many people don't realize that doing so leaves themselves open to a potential tax liability, nicknamed the nanny tax. Let's take a closer look.

1. You Can Pay Up to Certain Amounts Without Triggering Nanny Tax

The nanny tax is designed to ensure that your household employees get credit for their work for purposes of Social Security, Medicare and unemployment benefits. As a result, the rules governing when the Internal Revenue Service collects the nanny tax track the income thresholds for various features of those programs.

Specifically, if you pay cash wages of $1,900 or more, then you have to pay Social Security and Medicare taxes of 15.3 percent. You're allowed to withhold half of that amount from what you pay your household employee, just as Social Security and Medicare taxes are withheld from most paychecks. Similarly, if you pay a household employee $1,000 or more in any calendar quarter, then you'll owe 6 percent in federal unemployment tax on up to $7,000 in annual wages.

2. Hiring Kids Under 18 Can Save You a Lot of Trouble

The nanny tax can be a huge hassle when you hire household employees, but there are some exceptions even if you pay more than the threshold amounts above. Paying members of your own family lets you take advantage of more lenient rules. If you pay your spouse or your under-21 child to do any household work, then any pay isn't treated as wages subject to the nanny tax.

A more common way to avoid the nanny tax is to hire babysitters, lawn-care providers and others under the age of 18. As long as the employee isn't primarily in the business of providing those services -- such as being a student in school at the same time -- then you won't have to pay the nanny tax on those wages even if they exceed the $1,900 limit.

However, the unemployment-tax component of the nanny tax isn't subject to the under-18 rule. So if you pay more than $1,000 in a quarter, it doesn't matter that the person is under 18 -- you still have to deal with the tax.

3. Using a Contractor -- Not an Employee -- Can Save You Money

The nanny tax only applies to those who qualify as employees as opposed to independent contractors. Although the distinction can be complicated, the primary way to understand when someone is an employee is to focus on the degree of control you have over their work. If you have control not just what type of work is done but also the specific way the worker does it, then you're more likely to have an employee. On the other hand, if you merely say you want a task done but leave the details to the worker, that resembles an independent contractor relationship more closely. In addition, if the worker provides tools and equipment rather than relying on you for them, that's another sign of a contractor relationship.

Properly classifying a worker is essential. If your worker isn't an employee, then you don't owe the nanny tax, as the worker is responsible for any self-employment taxes from earnings. But if the IRS disagrees with your characterization, then you can end up having to pay interest and penalties.

The nanny tax isn't generally a huge burden financially, but it can come as a surprise if you're not prepared for it. By being aware of when the nanny tax applies, you can take steps to avoid it and save yourself some money as a result.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+. Motley Fool retirement experts have created a free report on a simple strategy to use a little-known IRS rule to boost your retirement income.
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