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Photo: Sharon Mollerus, Flickr

There are reportedly morethan a million nannies at work in the U.S., caring for other people's children. That's not so surprising, considering that many nannies today earn more than $50,000 per year, and some earn more than $100,000. Employing a nanny means more than conducting a lot of interviews and finding someone who knows CPR, though. There are important tax considerations, for example.

First off, note that when it comes to taxes, nannies are in the same category as many other kinds of domestic workers (yard workers, health aides, house cleaners, and so on), even though they sometimes earn much more -- and it can be a tough way to earn a living. For example, accordingto the National Domestic Workers Alliance, 23% of all domestic workers earn less than minimum wage, and two-thirds of those who live in their employers' home earn less. Fewer than 9% have employers who make contributions toward Social Security, and hardly any get retirement benefits. A typical nanny salary is roughly $35,000per year.

Employers make a host of mistakes when it comes to taxes for nannies and domestic workers, sometimes intentionally and sometimes not. Let's back up a bit, though, to get on the same page as the IRS. The IRS explains household employees and their taxation in its Publication 926. In general, if you pay a qualifying household employee $1,900 or more in 2014 in cash wages, you must withhold and pay Social Security and Medicare taxes. These total 15.3% of cash wages, 7.65% of which is owed by both you and the employee. Some employers choose to pay the worker's share, too. If you pay a qualifying employee $1,000 or more in cash wages in a quarter, you must also pay federal unemployment tax of 6% on cash wages up to $7,000. Earnings beyond $7,000 are not taxed, and the tax you pay may be reduced if you also pay state unemployment taxes. 

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Photo: Peter Moons, Flickr.

Some nanny employers mistakenly consider their nannies independent contractors who are simply paid and handle their taxes on their own. (According to the folks at Care.com, 20% of employers file a 1099 form for their nanny.) But someone who, for example, works according to your specified schedule and performs tasks in ways that you demand (i.e., kids must do homework before dinner, which must be at 6 p.m.) isn't a contractor. Treating your nanny as an independent contractor has you running afoul of IRS rules, and it will also cost your nanny more money, as she (or he) will be on the hook for the entire 15.3% in Social Security and Medicare taxes.

Meanwhile, know that if your nanny works more than 40 hours in a week and doesn't live with you, you must pay overtime. If he or she does live with you, you might still need to pay overtime, depending on which state you live in. Your nanny must also be a U.S. citizen, or an alien allowed to work in the United States. You must have your nanny fill out an I-9 form and keep it with your records.

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Were Mary Poppins's earnings taxed? We'll never know. Photo: Sam Howzit, Flickr.

Follow the rules -- and be rewarded
It's estimated that more than 75% of employers of domestic workers pay them under the table. If you're thinking that since others get away with not following the rules, you might try to avoid paying nanny taxes, too, think again -- because plenty of rule-breakers get caught. This can happen if your nanny applies for unemployment benefits or Social Security disability or retirement benefits at some point. It will soon be clear that those benefits are not available because employer taxes weren't paid, and that penalties, interest charges, and back taxes are in order.

There's an incentive, too, to stay on the high road: tax benefits. There are two key ones to know about:

  • Dependent-care accounts: If you work at a company and you incur expenses to care for a child or dependent (nanny expenses, for example), you may be allowed to set up a dependent-care account, funded with up to $5,000 of your earnings, from which you pay those expenses, avoiding taxation on that portion of your earnings.
     
  • The Tax Credit for Child or Dependent Care: Alternatively, you may be able to claim a tax credit of 20% to 35% of child care expenses that qualify, based on expenses of up to $3,000 for one dependent or up to $6,000 for two or more. The percentage allowed is based on your income level.

These tax benefits can sometimes save you more than you would owe in employer taxes, so they're well worth investigating. Note that you can only take advantage of one of them at a time, not both.

Employing a nanny (or other domestic workers) offers lots of benefits for you, such as care for your children, but it also comes with financial responsibilities and involves a certain amount of work, such as record-keeping. If you're skirting the law, intentionally or not, you're doing a disservice to your employee and probably yourself, too. Take some time to learn the rules -- at sites such as Care.com, Nanny.org, and even IRS.gov -- and you might end up saving money while staying within the law.

Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. Nor does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.