How & When To Minimize Your Self-Employment Taxes
Nobody I know enjoys paying more in taxes than they should, whether that’s income tax, Social Security and Medicare (FICA) tax, property tax, sales tax or any other type of tax. With regard to FICA taxes, when you are an employee, you generally pay a total of 7.65% of your income toward FICA taxes. Of that, 6.2% on the first $118,500 (in 2015) of eligible wages goes toward Social Security, with 1.45% going toward Medicare with no wage cap. Your employer pays an additional 7.65% on your behalf. Note: this rate does not include the 0.9% Medicare surtax that is charged to individuals with earned income of more than $200,000 (or married couples with more than $250,000).
When you are self-employed, you are responsible for the full 15.3%, since you are effectively the employer and the employee. Many of those that are self-employed (set up as either sole proprietors or pass-through entities) report their income each year as their total net income from their business. However, one of the benefits of being self-employed is that you can structure your company so that you can take income with a portion being considered a reasonable salary and a portion being considered a shareholder distribution. That sounds like a lot of work, so what is the benefit?
Benefits & Drawbacks Of Shareholder Distributions In Lieu Of Salary
While you will be subject to income tax on all of your net income, regardless of whether you take it as salary or as a shareholder distribution, you will typically only pay FICA taxes on the salary portion. This provides an opportunity on both the tax side and the financial planning side.
For example, if your net income from a business in a given year is $100,000 and you report that all as salary or wages, you will pay $7,650 in FICA taxes on the employee side and $7,650 on the employer side for a total of $15,300 in FICA taxes. However, if you take a salary of $52,000 and a shareholder distribution of $48,000, you would only pay $3,978 ($52,000 x 7.65%) on the employee side and $3,978 on the employer side, for a total of $7,956 in FICA taxes. In this example, you would save $7,344 in FICA taxes by categorizing a portion as salary and a portion as a shareholder distribution.
So why wouldn’t you do this? Because you must keep in mind that reporting a lower salary, and consequently paying less in FICA tax each year, may ultimately reduce your Social Security retirement benefits. So, it is a way to save taxes in the short-term, but it is not a decision to be taken lightly, as it can affect the lifetime of Social Security benefits you will collect in the future, and it can negatively impact your overall retirement income if you do not utilize the FICA “savings” properly.
Without getting too in-depth on how Social Security benefits are calculated, the basic procedure is that the Social Security Administration (SSA) indexes all of your reported years of wages for inflation, takes the sum of the highest 35 years of indexed earnings, and divides that total by 420 (35 years x 12 months per year). The resulting number is the Average Indexed Monthly Earnings (AIME) and that is used to calculate the Primary Insurance Amount (PIA), which is the benefit amount you would receive if you began collecting Social Security at your full retirement age.
Given that your Social Security benefits are determined using your highest 35 years of indexed earnings, the less you earn during those 35 years, the lower your benefits should be; the more you earn during those 35 years, the higher your benefits should be. This is where the decision of whether business owners should “lower” their salary to avoid FICA taxes comes into play.
Choosing Between Lower Taxes Now & More Benefits Later
The decision comes down to at least a couple of factors. One is your level of earnings that will ultimately be used in determining the AIME and how that compares to the “bend points” that are used in calculating the PIA. The higher your earnings over the course of your career, the more likely it is that your AIME will surpass the first, and possibly even second, bend points. If your AIME is past the first bend point, the increase to the Social Security benefit is diminished, and is even more diminished if your AIME goes past the second bend point.
In other words, the higher your indexed earnings (which leads to a higher AIME), the less dramatic the impact of lowering your salary is likely to be to your future Social Security benefits. However, if your AIME would be under the first bend point, reducing your income to try to avoid FICA taxes could have an outsized negative impact on your future benefits.
The other major factor is what you think will happen to the Social Security system over the next 20-30+ years. While a detailed discussion of options to increase the program’s long-term solvency is the subject of a different article, I believe that Social Security will be around for a very long time. However, it also seems quite evident that changes will need to be made in order to achieve that longevity, meaning the program will likely look different at some point in the future than it does today. We have already seen one recent step with Congress closing the file-and-suspend “loophole” in their October 2015 budget deal.
As a consequence of future changes, there will be a heavier emphasis on providing as much of your own retirement income as possible. That is why I suggest that people, especially those in the younger generations, plan as if Social Security will not be around when they are older, and then any benefit they do receive will be icing on the cake. This uncertainty also means it may be worthwhile for younger generations of self-employed to take steps to avoid higher FICA taxes now, even though they know that that could reduce their future benefits.
However, this strategy will only prove beneficial if you take those FICA “savings” and actually save and invest them elsewhere in order to grow your personal portfolio of assets to use during retirement. In other words, you do yourself no good if you lower your earnings to save on FICA taxes (likely lowering your future Social Security benefits) if you go out and spend the FICA “savings.”
Rather, the concept is that you are trading lower future Social Security benefits for increased savings, investments, and control over your money. Essentially, you want to make yourself better off from a tax perspective in the short-run and better off from a savings and investment perspective in the long-run. If you don’t put the FICA “savings” away for the future, you will end up being better off from a tax perspective in the short run, and worse off from a savings and investment perspective in the long-run. In other words, you would be trading short-term gain, for long-term pain.
Final Thoughts: Consider & Consult
As with anything, everyone’s situation is different and whether you should actively attempt to lower your earnings base to avoid higher FICA taxes is no different. Given the implications with regard to taxes and future Social Security benefits, you should consult with your CPA and financial planner prior to setting up such a structure.
As noted, lowering your income that is used to calculate your Social Security benefits can negatively impact the level of benefits you receive in the future. So, it may not make sense for all taxpayers to take steps to avoid FICA taxes. However, in the right situation it can make a lot of sense not only in the short-term, but for your long-term benefit as well.
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