Nanny v. Daycare– the Impact on Your Taxes
Welcoming a new baby into this world can be one of the best days of a parent’s life. They may begin to wonder what this tiny bundle of joy will be one day. Perhaps a teacher, a doctor, or an artist. They may spend sleepless nights worrying if they should do baby-led weaning, or if they should switch to a different kind of sippy cup. Most times, they are not thinking about all the ways this baby can affect their taxes. Particularly, when the parent returns to work, how childcare can have an impact on their tax liability.
There are different tax implications for the two main sources of childcare: hiring a nanny who works in the home and sending the child(ren) to a licensed daycare outside of the home. The most tax-beneficial option will depend entirely on personal circumstances.
Hiring a nanny to care for the child(ren) in the home may be a great option for some. The nanny would be considered a household employee and would need to be reported on Schedule H of the 1040 if the nanny is paid more than $2,600 in cash wages for the year (adjusted annually for inflation). The employer would then need to withhold and pay FICA taxes (benefitting Social Security and Medicare) and Federal Unemployment Tax Act (FUTA) taxes on behalf of the employee. These taxes are paid when the income tax return is filed or extended, and it should be considered in planning tax estimate payments to avoid underpayment penalties. If a Schedule H is required, an employer identification number (EIN) will also be required for the employee to report the income on their tax return.
According to the IRS, a household employee is a person who performs domestic service in the employer’s home. They may work full or part-time, and they may be paid hourly, weekly, or by the job. The employee may not be the taxpayer’s spouse or taxpayer’s child under the age of 21.
Daycare centers can be another great option for some families. The IRS requires these centers to maintain the following characteristics in order to be a qualified option:
- Provide care for more than six persons, and these persons must not live there on a regular basis;
- Receive a fee, payment, or grant for providing care services, regardless of whether the facility is operated for profit; and
- Be in compliance with state and local regulations.
For some families, this may be a preferable alternative as they would only need to track the payments given to the daycare center. It is important to note that older children who have aged out of daycare may have qualified care expenses by attending before-school or after-school care, having a babysitter, or attending summer camp.
Child and Dependent Care Tax Credit
The good news is that either hiring a nanny or sending your child to a daycare center qualify for the Child and Dependent Care Tax Credit. This credit is designed to help parents with childcare expenses maintain gainful employment. If the taxpayer is a full-time student or unemployed for part of the year, they may still qualify. A qualified child is one who is under 13 years of age or a disabled dependent of any age and meets the dependency exemption criteria. The credit is nonrefundable.
The credit amount can be up to 35% of employment-related expenses and goes down to 20% for those with an Adjusted Gross Income (AGI) over $43,000. The maximum amount of expenses that can be considered for this credit is limited to $3,000 for taxpayers with one qualifying child, or $6,000 for those with two or more qualifying children. The taxpayer will need to fill out Form 2441 to figure the exact credit amount. The calculated amount will be shown on Schedule 3 of the 1040. Employment-related expenses can include the payments made to a nanny or daycare or the taxes paid for employing a nanny. The expenses may not include gifts made to a nanny or the cost of snacks sent to daycare.
In 2022, Pennsylvania began to offer a state tax credit that follows the federal credit. If a taxpayer qualifies for the federal Child and Dependent Care Tax Credit, they will generally be eligible for the PA credit. The credit is equal to 30% of the federal credit, bringing the maximum state credit to $630.
Summary When choosing childcare, it is worth considering all available options and how they may impact a person’s tax liability. For some, a nanny is worth a little extra paperwork and cost. For others, it may be more beneficial to have care outside of the home and not to have the extra payroll filing requirements. The great news here is both options are eligible for the tax credit.