Money Girl answers 7 common questions about paying income tax that will help you comply with the law, minimize what you owe, understand tax deductions and credits, pay household workers or nannies properly, and avoid trouble if you can’t pay Uncle Sam on time.
Question 5: What’s the difference between tax deductions and credits?
Both tax deductions and credits reduce the amount of tax you must pay or increase your tax refund. Deductions reduce the amount of income you pay taxes on, which in turn reduces your tax.
A tax deduction is an amount that the IRS allows you to subtract from your taxable income. When you reduce your taxable income, you lower your tax liability. For example, if your taxable income is $40,000 and you’re eligible to claim $10,000 in allowable tax deductions, then you only have to pay tax on $30,000—not $40,000. That makes a huge difference!
Tax credits are a dollar-for-dollar reduction in the amount of tax you owe, which can be more valuable than a deduction. For example, if you owe $1,000 in taxes, getting a $600 tax credit means you’d save that full amount and only owe $400.
Question 6: Do I have to pay taxes for a household worker or nanny?
Several folks in my Dominate Your Dollars Facebook Group brought up the topic of paying a nanny or other household worker correctly. This is an interesting question because many people don’t realize that they are actually an employer and must provide a formal payroll with multiple taxes deducted and filed, just like a business.
“Nannygate” is a popular term for problems in the early 90s that caused two of President Bill Clinton’s choices for Attorney General to go down the drain. It was discovered that both nominees had broken federal law by employing undocumented workers and failing to pay taxes.
So, what do the less rich and famous need to know? It’s critical to understand that if you hire workers to care for your children or to do housework that they are generally considered your employees. But note that if you’re a business owner or self-employed, you can’t just put a nanny on your company’s payroll. You must pay him or her separately.
An employee is someone whose work you control. It doesn’t matter if you control the work full- or part-time, if you found them through an agency, or if you pay by the hour, day, or job. As an employer, it’s against the law to pay a nanny in cash and avoid paying taxes—even if your nanny prefers receiving cash and being “off the books.”
The only household workers who are not your employees are those who control how they work or who are self-employed. However, if an agency provides a worker and also controls how their work is done, the agency is the employer, not you. Therefore, in the vast majority of cases, you can’t consider a household worker a contractor and issue a Form 1099.
If you employ a nanny, babysitter, or household worker and pay him or her more than $1,000 per quarter, or $2,100 a year, you’re generally responsible for reporting their income on Form W-2.
You must withhold income, Social Security, and Medicare taxes—and pay overtime for hours worked over 40 per week. And depending on where you live, there may be benefits you must legally provide, such as paid sick time and workers’ compensation insurance.
Not only is it illegal to skip paying tax for household workers, but it’s unfair to them. By not paying tax, you’re costing him or her their future Social Security and Medicare benefits.
Yes, paying a nanny properly by calculating and withholding taxes, issuing annual tax forms, maintaining the right records, and understanding employment law is confusing and time-consuming (especially if you don’t have experience running a business).
So, I recommend using a payroll service or accountant to handle the details for you. Check out services such as HomePay and SurePayroll to take the stress out of being a household employer. Prices range from about $40 to $70 a month.
After all, you hire a household worker to save time, not to spend hours each week processing paychecks and trying to stay compliant. You can also check out IRS Publication 926, Household Employer’s Tax Guide to learn more.
Question 7: What if I can’t afford to pay my taxes?
If you can’t pay Uncle Sam, you must still file tax a return. Failing to file on time results in late fees and penalties. Then can make arrangements to pay what you owe.
But always pay what you can, even if it’s less than the full amount owed. That will help minimize interest and fees.
The IRS offers a variety of payment options including short- and long-term payment plans, depending on how much you owe. But remember you’ll still owe interest, and possibly penalties, even if you enter into a payment agreement.
You might also qualify for an offer in compromise, which is a settlement to pay less than the full amount you owe. The IRS may also agree to temporarily delay collection until your financial situation improves.
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Tax form with glasses and pen image courtesy of Shutterstock.