The Nanny Tax: How to Offset the Added Costs

A friend just asked me to weigh in on the "nanny tax" issue. She's about to hire her first babysitter and wants to pay her on the books. But she's concerned that making the situation "legal" will cost her some money and that she'll have to lower the sitter's salary to compensate for her added expenses. And if she offers a caregiver less, she's afraid she won't be able to find someone capable and loving.

Many families have faced this very issue. But if you ask Uncle Sam what you should do, the answer is pretty clear cut. The law requires you to pay taxes whenever you hire a full-time sitter (or someone you're paying more than $1,700 a year), unless your nanny is your own parent or child.

Fortunately, there are a couple of ways you can offset the expense so you can still offer a sitter a competitive salary.

Dependent Care Flexible Spending Accounts
If your employer offers it, you'd be a fool to pass up this savings opportunity. Dependent care flexible spending accounts (FSAs) allow parents to set aside up to $5,000 in pretax money to help pay for child care. (Some employers may, however, limit how much you can contribute into such an account.) How much you'll save will depend on your tax bracket. To see how much it's worth for your family, check out this flex spend calculator.

The rules are pretty straight forward for dependent care FSAs. The main restrictions are that the government only allows families to use this tax break when both parents are working or in school full-time (for at least five months of the year). The child must also be under the age of 13. And, most importantly, you can't open an account if you pay your nanny under the table.

The Child and Dependent Care Credit
Parents can also offset the nanny tax by tapping the Child and Dependent Care Credit. This one is worth 20% to 35% of child care expenses up to $3,000 for one kid and $6,000 for two or more children. The rules are similar to those for flexible spending accounts and can only be used by working parents (or students) with small children. Disabled parents and those looking for work also qualify.

Here's the best part: Parents can tap both tax breaks provided they have steep expenses. (You can't claim the same expenses for both the credit and the FSA.) But fulfilling that requirement shouldn't be a problem if you're paying a full-time nanny.

As for the logistics, it doesn't have to be difficult to pay your share of your babysitter's taxes. There are a handful of online services -- including GTM Payroll Services and PayCycle.com -- that streamline the process and even cut the checks for you in exchange for a small annual fee.

Do I pay the nanny tax? I manage to dodge the whole situation by putting my kids in day care.

Do you pay your sitter under the table or on the books?

Stacey Bradford is the author of The Wall Street Journal Financial Guidebook for New Parents.
Baby image courtesy of Flickr, CC 2.0.
More on CBS MoneyWatch:
Parents: 3 Family Tax Deductions You Shouldn't Miss
How Flexible Spending Accounts Can Save You Big Bucks
What a Child's Sniffle Costs
How to Spy on Your Day Care Provider