The American Rescue Plan and the Nanny Tax
With the tax cuts in the American Rescue Plan reducing the costs of childcare for families, your clients may actually save money by paying their nannies legally if they are not doing so already. Tax breaks, including those in pandemic relief legislation, are obviously not available to families who pay “under the table.”
If there was ever a time for your clients to start paying their nannies the right way, it is now. Here’s why:
Increased Contribution Limits to Dependent Care FSAs
The American Rescue Plan boosts the Dependent Care FSA contribution limit from $5,000 to $10,500 for 2021. These accounts allow tax-free reimbursements for qualified child care expenses like wages paid to a nanny, lowering taxable income so less is paid in Social Security, Medicare and federal income taxes (state taxes too if applicable).
Tax savings from funds placed in a Dependent Care FSA can typically range from 32 to 46 percent. If your client has a full-time nanny (or even a part-time caregiver) they can max out their contribution and save anywhere from $3,400 – $4,800.
Expanded Child and Dependent Care Tax Credit
Under the American Rescue Plan, the Child and Dependent Care Tax Credit will increase from $3,000 to $8,000 for a family with one child. For families with two or more children, the credit increases from $6,000 to $16,000.
As with a Dependent Care FSA, a nanny’s wages are considered a qualifying expense under the Child and Dependent Care Tax Credit. The amount of the credit gradually decreases based on a family’s household income from 50 percent of qualifying expenses for households with an adjusted gross income (AGI) of less than $125,000 to one percent for households with an AGI of $440,000.
Currently most families receive a 20 percent credit of childcare expenses ($600 for one child or $1,200 for two or more children). With the American Rescue Plan, a family with an AGI of $185,000 – $400,000 can get that same 20 percent credit but now would get $1,600 for one child and $3,200 for two or more children.
Tax Savings Under the American Rescue Plan
In 2021, you can apply up to $16,000 of childcare expenses towards tax breaks (Dependent Care FSA and the Child and Dependent Care FSA) if you have two or more children. The maximum is $8,000 for one child.
If your client has a full-time nanny caring for their two children, they can apply $10,500 of their wages to a Dependent Care FSA and then use the remaining $5,500 for the Child and Dependent Care Tax Credit. Let’s say your client employs a nanny earning more than $16,000, files as married filing jointly, and has an AGI between $185,000 and $400,000.
For one child, their tax savings would be:
- Dependent Care FSA: $3,400 – $4,800 (depending on a maximum contribution of $10,500; federal income tax bracket; and any possible state income taxes) or;
- Child and Dependent Care Tax Credit: $1,600 (20 percent of $8,000 of qualifying expenses)
If your client maxes out their Dependent Care FSA, then they would not be able to take the Child and Dependent Care Tax Credit. If they do not have a Dependent Care FSA, then they would apply the maximum amount of expenses to the tax credit.
For two or more children, their tax savings would be:
- Dependent Care FSA: $3,400 – $4,800 (depending on a maximum contribution of $10,500; federal income tax bracket; and any possible state income taxes); and
- Child and Dependent Care Tax Credit: $1,100 (20 percent of $5,500 of qualifying expenses after accounting for the dependent care FSA)
This would be a total of $4,500 – $5,900 in tax savings.
In this case, your client has expenses leftover after contributing the maximum amount to their Dependent Care FSA. They would be able to apply additional expenses of up to $5,500 to the tax credit.
Saving Money by Paying Legally
It always makes sense for clients to pay nannies legally. Here is how it can save them money in 2021 (and maybe beyond).
Scenario #1
- Nanny gross wages of $25,000
- One child
- A family filing as married filing jointly
- AGI of more than $183,251
| Wages Before Taxes | $25,000 | |
| Employer Share of FICA | $1,912.50 | |
| Federal and State Unemployment Taxes | $700(approx.) | Costs will vary by state |
| Total Costs Before Tax Breaks | $27,612.50 | |
| Dependent Care FSA Savings | $3,300-$4,600 (approx.) | Max amount contributed for tax brackets between 24% – 37% |
| Total costs w/tax savings | $23,012.50 – $24,312.50 |
By paying legally your client can save between $700 – $2,000.
Scenario #2
- Nanny’s gross wages of $40,000
- Two children
- A family filing as married filing jointly
- AGI between $185,000 – $440,000
| Wages Before Taxes | $40,000 | |
| Employer share of FICA | $3,060 | |
| Federal and State Unemployment Taxes | $700 (approx.) | Cost will vary by state |
| Total Costs Before Tax Breaks | $43,760 | |
| Dependent Care FSA Savings | $3,300-$4,600(approx.) | Max amount contributed for tax brackets between 24% – 37% |
| Child and Dependent Care Tax Credit | $1,100 | applying the 20 percent credit to the remaining $5,500 in childcare expenses |
| Total Costs w/Tax Savings | $38,060 – $39,360 |
Even by paying more in employment taxes due to higher wages, your client could still save more than $600 by employing your nanny legally.
GTM Payroll Services provides these calculations as a means for understanding an estimate of tax liabilities but should not be used as a replacement for formal calculations and does not constitute the provision of tax or legal advice. The user assumes all responsibility and liability for its use.
Beyond 2021
The increased tax savings from Dependent Care FSAs and the Child and Dependent Care Tax Credit is limited to 2021. However, there is a strong possibility that these changes may be made permanent when Congress takes up comprehensive tax reform later this year.