How to pay an undocumented nanny

You can't do tax withholding for an undocumented worker as they don't have a valid SSN (they might give you one, but it belongs to a different person and that can create a major headache for the true owner of the SSN). So your only option is cash.

If you want to do the above-table things and do tax withholding, you need to find a nanny that is legally permitted to work in the US. Yes, those nannies do exist.

If you don't want to pay someone legally then you cannot withhold taxes (they need to have a SSN or taxpayer ID). 

You either need to pay cash (no records) OR you need to have someone for whom you can report their income to the government and withhold taxes. Some people have a fake SNN which is of course illegal ...

If you pay someone for whom you don't report income, you are putting both you and the employee at risk - both would be responsible for back taxes. If you are likely to be audited by the IRS then this might be a more important concern. Plus then the employee is not paying disability taxes and is therefore not eligible for those benefits including state paid maternity leave.  Spending cash means it is harder for the government to track where the money goes. But then paying cash means you are providing employment for someone who does not have any other legal access to money ... anyway, this is a complex issue. 

One other thing to consider: you cannot use your pre-tax dependent care dollars for someone you are paying cash. You need to show your employer a pay stub for the nanny ... and you cannot do that for someone getting paid in cash without records. 

When we were looking for a nanny we stipulated in the job posting that we would pay over the table and withhold taxes and we found nearly all applicants were then happy to comply with this ... 

We have done both (paying both "off" and "on" the books). We asked our employee for her preference and followed what she requested. Paying "on the books" can be done using an ITIN (individual taxpayer identification number) in place of a SSN. An ITIN is not (in theory) reported to ICE; there is (in theory) a strong firewall between IRS and ICE. Here is some information about it:
http://info.homeworksolutions.com/blog/nanny-taxes-and-the-undocumented…

Paying "on the books" is a lot more work and it will cost more for both you and the employee. (I highly recommend using a service if you can afford it - much less work for you.) However, there are benefits. 1. it gives access to certain government benefits, for example, in case she becomes disabled while on the job. 2, it is the right thing to do (you could still be in trouble with immigration for employing someone who is not authorized to work, but it's not tax evasion, which is a felony). 3, if your nanny is ever in a position to possibly obtain legal status in the US, showing that she has been paying taxes is a big plus for her case and could make them more likely to give her legal status. (I know, it's kind of messed up to expect someone to pay taxes when they weren't supposed to be working, but that's US immigration policy for you.)

It's important to know that even if you are paying off the books, the person is still your employee (not an independent contractors). Also, ALL labor law applies to workers regardless of their documentation status. So whatever their status, whichever way you are paying, you are still obligated to give overtime pay, minimum wage, etc. Here is some more information about legal responsibilities and best practices:
http://domesticemployers.org/qa/

If your nanny provides you with a ITIN, you can pay on the books and withhold taxes (which is better for your nanny if he/she ever intends to apply for legal residency). However, you will not be able to use a dependent care FSA (that requires the provider's social security number). If you are paying off the books (as countless people do even with nannies who are legal to work in the U.S.--but that's another post entirely!) you need to pay in cash. In past years, the IRS has often looked the other way on work status as long as they got their money. Honestly, though, in this political climate, I would not risk this and would certainly not assume that the federal government's inaction around this issue will continue. That could cause problems for both you and your nanny (and also complicates things like workers' comp and car insurance, which may not cover your nanny). It's a tough situation.

Yes, it is illegal to hire an undocumented worker thus you don't have a choice about paying them as "an employee with appropriate withholding". You have to pay cash.

As someone who has hired childcare providers of all kinds for long term commitments, including undocumented nanny doing a nannyshare, unlicensed in home daycare, licensed preschool, and a legal on-the-books afterschool babysitter, I would say it's not that hard to find a household employee with legal status IF you are looking at the right time of year, ie., summer for a job starting on a school year cycle. Looking in December for a job starting January is second best. Any other time of year is seriously tough, in my experience.

I regret having used an undocumented worker as a nanny. In retrospect, it puts all parties in an awkward position including the nanny's worker protections. If someone gets hurt, it creates problems for your homeowners insurance claims, and if something happens involving the police (even if the nanny is just a witness) it could start serious problems for the nanny. I recommend finding a legal employee. After a few pay cycles, it's not that arduous to handle the paperwork for pay him/her. (My husband did it himself but you can also use a payroll service.) We felt like our hands were clean and our employee was protected. There was no increase to our homeowners insurance as household employees are covered.

In the future you can avoid this problem by specifying in your job description that you will be paying legally and employee must have proof of ability to work in the US. Don't interview anyone who can't confirm they have that status.

I would also add that paying on the books is easy. We use surepayroll.com - a call to set everything up, some paperwork for the nanny (that you need anyway) and a link to our checking account was all it took to get sorted. They file quarterly statements with the state, generate IRS statements each year, send our tax money to the IRS ...and I can pay the nanny through their website in about 2 minutes. The service is ~$20/month. Don't do the paperwork yourself, it is super confusing and a hassle. If you can afford a nanny you can afford this service.