Business owners and the self-employed have been hit with a double whammy from wages and Social Security taxes. To put it another way; if you’ve been self-employed throughout your career, you’re likely to pay double the tax on the same Social Security benefits as someone who worked as an employee throughout your career. By strategically minimizing payroll taxes and maximizing contributions to your small business retirement plan, you may get more out of it.
I specialize in tax planning and financial planning for high-income business owners. I’m often asked how they minimize taxes while getting meaningful Social Security benefits. The knee-jerk reaction may be to raise their wages to the maximum of Social Security benefits, bite the bullet, and pay massive income and payroll taxes. While my clients are from all over the country, I am a financial advisor in Los Angeles and most of my clients are also subject to California’s high income tax.
Business owners hit by double payroll tax
Before you freak out, it’s not a terrible tax to hurt business owners. When you are self-employed, you can enjoy the benefits of annual social security contributions to employers and employees. The Social Security Administration (SSA) receives the same amount of funds (total) whether you are an employee or a business owner. In 2022, the self-employment payroll tax on your first $147,000 of income is 15.3%. The 15.3% payroll tax includes 12.4% Social Security and 2.9% Medicare.
There’s some good news for those earning more than $147,000. The Social Security part is gone. You pay Medicare an additional 2.9% of your income. Ultimately, the 3.9% Medicare surcharge affects higher incomes. The Medicare surcharge is $200,000 for single filers and $250,000 for married filers filing jointly.
S-Corp Payroll Tax Savings
Business owners with substantial income can limit how much of their income is affected by the payroll tax. Employee owners must pay their own reasonable wages, subject to payroll taxes. Profits remaining each year can be distributed without withholding payroll taxes. Be sure to consult your tax professional and financial planner about a reasonable salary based on your income and job responsibilities.
Running extremely low wages can help you minimize payroll taxes, but it also reduces your eventual Social Security benefits. If you use the tax savings to add more money to your retirement account, such as a Solo 401(k) or a cash balance pension plan, this shouldn’t be a big problem. On the other hand, if you use your tax savings to spend, spend, spend, you may not be able to invest enough to support your standard of living in retirement.
Should you increase your salary to increase Social Security benefits?
There are no easy, quick, and easy answers to how much income you should put on the payroll to maximize retirement income. Yes, increasing your income (and paying more taxes) through your payroll will increase your Social Security benefits, but by how much? This conversation gets more complicated if your spouse also has benefits or is self-employed.
I would say that, in general, if a married couple is working together, it’s usually not good for you to pay both spouses equally. For example, if your business has $500,000 in revenue, you wouldn’t want each of you taking a $250,000 salary. This means more of your income will be affected by payroll taxes. Conversely, for a business driver, a reasonable salary might be $100,000, for example, a reasonable salary might be $30,000 to help a second spouse in a more managerial role. (Just an example here). The remaining $370,000 will be distributed as profits.
Higher Salary Brings Higher Retirement Plan Contribution Limits
Another reason to earn a higher salary is to allow for larger retirement plan contribution limits. For a 2022 Solo 401(k), you can contribute $20,500 as an employee and the employer (and you) can contribute up to 25% of your salary as a profit-sharing contribution. Business owners age 50 or older can also contribute up to $6,500 as an employee, for a total pre-tax contribution of up to $67,500. You’ll need a salary of at least $162,000 to make the maximum allowable Solo 401(k) contribution in 2022.
Those with higher incomes should look into cash balance pension plans. I made a proposal earlier this year that teams of husband and wife business owners could contribute more than $700,000 between their 401(k) and cash balance pension plans. As their tax planning financial advisor, I ran the numbers. I’m sure if they’re willing to pay more in payroll taxes (we raised their paychecks to allow maximum contributions to retirement accounts), they could reduce their federal and California income taxes. Remember, they only pay 15.3% payroll tax on the first $147,000 of each paycheck. At their income level, they face 37% federal tax and 13.3% state tax.
Tax planning is part of running a business. It’s not just how much you earn, it’s how much you keep. If your business income grows, the value of active tax planning grows exponentially. Some tax reduction strategies need to be implemented during the calendar year, so don’t delay until the tax filing deadline to consider your taxes.