Overcoming the Tax Dilemma

By Stephanie Breedlove, Founder of Breedlove & Associates

We had a nanny call us the other day with some tax and legal questions.  She was trying to decide whether or not to take a job and was torn emotionally.  The pros: she loved the family and the kids; the hours were ideal for her schedule; the family was “geographically desirable” (nearby); good vacation, holiday and health insurance benefits.

The only con: money.

She explained that the family insists on paying her legally.  She told the family that legal pay was fine as long as they “paid all the taxes.”  The family came back with an offer that would cover about half of the nanny’s taxes.  Her dilemma was whether or not to take a cut in her normal “take-home” pay in order to get the job.  She was noticeably frustrated because it didn’t seem fair to her that the family’s taxes were coming out of her pocket.

The nanny asked us: “Why won’t she either pay for all the taxes or just pay cash?  Why should I take a hit (financially) just so they can be legal?”

Coincidentally, the same Breedlove staff member took a call a few minutes later from a mom who lived in the same city.  She had identified a nanny candidate who she thought was perfect for her family.  However, the mom was concerned because the nanny had always been paid “under the table” and she didn’t know how she could afford a nanny if it meant “paying her taxes plus mine.”  Although she loved the nanny, she too was in a dilemma.

The mom asked us: “Why should I risk tax evasion and losing my law license just so she doesn’t have to pay taxes like the rest of the world?”

It was enlightening to hear the dilemma from both perspectives simultaneously.  Perhaps most striking was the employee’s misperception that the impasse was due to the family’s taxes.  She did not see the taxes as her burden nor did she recognize that she would benefit from them.

As with most obstacles, mutual understanding helps.  When each party can see the other’s point-of-view, it becomes much easier to find common ground.

So, in case you know someone in this dilemma, here’s what we shared with the nanny.

“Paying all the taxes” has three important components.  First, it means covering your employment taxes – which fund programs that provide important short-term and long-term benefits/protections, such as income and medical benefits during retirement.  Your retirement benefits are calculated based on the amount of employment taxes paid over the highest 35 years of your career.  The more you put in, the more you get out.  Conversely, if you’re paid under the table, you will not be eligible for any income or medical benefits when you reach retirement age.

Second, “paying all the taxes” also means covering your federal and state income tax withholdings, which are estimated pre-payments against your income tax liability.  Like the employment taxes, income taxes are the responsibility of every American worker.  It’s the law.  And the IRS makes life miserable for those caught evading taxes.

Third, in addition to paying your employment and income taxes, the family also has additional employer obligations (widely referred to as “nanny taxes” although it applies to all types of domestic workers and it includes other non-tax costs).  The family must pay the employer’s share of Social Security & Medicare (they match what you pay dollar-for-dollar and it gets “credited” to your retirement account) as well as federal and state unemployment taxes, which pay for your unemployment benefits in the event that you ever get laid off).  In addition, many states require employers to purchase a workers’ compensation insurance policy and/or a disability insurance policy on behalf of the employee.

If the employer pays all of your obligations AND all of her employer obligations, the total cost to employ you will be your net (“take-home”) pay plus about 25-35%.  Using common sense, if your net pay is below the going market rate, employers may be willing to pay that premium.  However, if your net pay is at or near other nannies’ gross (legal) pay rate, you may price yourself out of the market – with very few families being willing or able to pay that premium.

Considering that – and considering that most of the taxes directly benefit the employee – many nannies who are transitioning to legal pay find it fair and reasonable to meet their employer somewhere in the middle and take on some of the tax burden themselves.

Obviously, it’s a trade-off: slightly less money every payday in exchange for professional benefits.  I think of it as a forced savings plan.  When you reach retirement age – and you’re actually able to retire – you’ll be very glad you made the small sacrifice when you were younger.

To what degree you’re willing to accept that trade-off is up to you, but we encourage you to factor in the details of your situation – i.e. how does the compensation package (pay, vacation, insurance, etc.) stack up against the fair market rate in your area and against other job options you may have?  Besides money, how does the quality and stability of the job compare? – as well as the peace-of-mind that comes from 1) following the law and 2) being entitled to the financial protections and benefits other professionals enjoy.

Before making a final decision, we encourage you and your employer to use our free Nanny Tax Calculator.  Have an open, honest dialog about the financial implications of various pay scenarios.  Hopefully, you’ll find a win-win compromise that creates a successful, mutually-beneficial employment relationship.