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Parents, prepare for the nasty nanny tax

If you employ a nanny or even a summer-time caregiver for your kids, prepare yourself for some bad tax news. Assuming you pay that person more than $1,900 annually (or more than $1,000 in a calendar quarter) and the caregiver is an adult working in your home, you are a household employer. And that opens you up for a world of hurt.

"It's a small example of what a commercial employer must do," says Stephanie Breedlove, vice president of HomePay. "To comply with the law, you have to withhold payroll taxes, remit them to the IRS and report wages to the state and the federal government on different quarterly schedules."

You may also need to calculate and pay unemployment taxes and worker's compensation levies to either the state or federal government, or both.

It's possible for a careful person to do this without hiring professional help, says Breedlove. But it's not easy.

On the other hand, hiring a company to do it for you can add to the often crushing cost of child care. Services like Breedlove's, which write payroll checks, file forms and taxes for you, run between $750 and $1,500 annually. On the bright side, says Breedlove, the cost is deductible for those who itemize.

What do you have to do, if you want to do it yourself? It's best to take it step-by-step:

Step One: Set up an account with both your state and the IRS. The agency offers advice on how to determine whether you're a domestic employer and provides instructions on how to fill out the appropriate forms online in its Publication 926.

However, in most cases, you'll need to call your state government to get the appropriate state forms and filing instructions, Breedlove says.

Step 2: Determine whether to deduct payroll taxes from your worker's weekly wags. You'll need to send 15.3% of the wages to the government for Social Security and Medicare taxes. Half of that cost is yours, as the employer. Technically, your worker needs to pay the other half. You can choose to pay the levy for the worker or deduct it from her pay. Either way, it's your job to send the taxes to the government.

Step 3: Put tax and reporting deadlines on your calendar and be certain to meet them. Failing to file and remit employment taxes is considered a serious offense -- tantamount to stealing from your worker -- and can result in serious penalties.

Step 4: Provide your worker with a W-2 form at year-end, showing how much she earned and the taxes that have been withheld during the year.

Step 5: Claim tax deductions for your child care expenses. You have two options. You can claim the child care credit on your 1040, or (if available) you can set up a dependent care account through your employer. Dependent care accounts allow you to set aside up to $5,000 in pre-tax wages annually to pay day care expenses. Child care credits allow you to recover up to 20% of your expenses. Parents of two or more children can sometimes qualify to take at least a portion of both breaks.

Of course, you can get these tax breaks by sending your kids to day care, too. And that eliminates the tax hassle of being a household employer.

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