The high price of child care is all too familiar to my family. The monthly cost of care for our toddler usually tops $1,000 and is second only to our mortgage payment. More than 70% of parents spend at least 10% of their income on child care, and more than half spend at least $10,000 per year, according to Care.com.

The coronavirus pandemic has added to the strain on working parents. Some have struggled to afford care following cuts in their pay or hours. Others have changed care providers or juggled job responsibilities and child care duties when schools and day care centers closed because of COVID-19. Parents have even left the workforce to care for their kids, removing care expenses from their budgets but losing income.

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The Tax Rules for Hiring a Nanny

Whether you’re seeking child care for the first time or you’re reevaluating your options, be sure you understand the financial implications. A nanny, who comes to your home, is convenient. But the average weekly rate to have a nanny care for one infant is $565, according to Care.com—much higher than the $215-a-week average for a day care center and $201 for in-home day care. One way to reduce expenses is to share a nanny with another family, with whom you can split the cost.

Plus, hiring a nanny often comes with tax implications. If you pay a nanny at least $2,300 in 2021, the IRS requires you to treat him or her as a household employee. You must withhold Social Security and Medicare tax from the nanny’s pay—and as the employer, you have to kick in Social Security and Medicare tax, too (you and the nanny each pay 7.65% of wages). You must also issue a Form W-2 each January and file other forms with the IRS. And you may be expected to cover transportation, meals and two weeks of vacation, says Dana Levin-Robinson, CEO of Upfront, a price-comparison website for child care services.

The expenses and tax complications that come with hiring a nanny were reason enough for me to take my son to day care instead. Consider other costs and savings, too. Day care centers and preschools may include snacks and meals in their rate. But they may also charge annual fees or penalties if you pick up your child late.

Tax Breaks for Child Care

If you have earned income from employment during the year and pay for care while you work or look for work, you can take a federal tax credit of 20% to 35% of care expenses (the percentage depends on your income) for up to $3,000 paid for one child or $6,000 for two or more children younger than 13. You can claim the credit whether the care is in or out of your home, and you must report the care provider’s name, address and tax identification number.  

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Your employer may allow you to stash up to $5,000 of pretax money annually in a dependent care flexible spending account. You can use the funds to pay for a nanny or day care while you work, as well as for before- and after-school programs or summer day camp. The recently passed COVID relief law includes provisions through which employers may permit unlimited carryovers of unused FSA funds from the 2020 plan year to 2021 (and from 2021 to 2022), or extend the grace period to use 2020 or 2021 FSA funds from 2.5 months to 12 months.