Business owners and the self-employed get hit twice as hard by payroll and Social Security taxes. Put another way; if you were self-employed for your entire career, you would likely pay double the taxes for the same Social Security benefits as those who worked as employees their entire careers. You may get more bang for your buck by strategically minimizing payroll taxes and maximizing contributions to your small business retirement plan.
I specialize in offering tax planning and financial planning for high-income business owners. I often get asked how they can minimize taxes while still accruing a meaningful Social Security benefit. The knee-jerk reaction might be to increase their salaries to the maximum for Social Security benefits, bite the bullet, and pay substantial income and payroll taxes. While my clients come from across the country, I am a Los Angeles financial advisor, and the majority of my clients are also subject to the high-income taxes of California.
Business Owners Get Hit with Double the Payroll Taxes
Before you freak out, this isn’t some terrible tax to hurt business owners. When you are self-employed, you get the benefit of paying employer and employee contributions to Social Security each year. The Social Security Administration (SSA) receives the same amount of money (in total) whether you are an employee or a business owner. For 2022, the self-employment payroll tax is 15.3% on your first $147,000 of income. The 15.3% payroll taxes include 12.4% for Social Security and 2.9% for Medicare.
For those earning more than $147,000, there is some good news. The Social Security component goes away. You are left paying 2.9% to Medicare for a bit on your additional income. Eventually, a 3.9% Medicare Surtax kicks in on higher incomes. The Medicare surtax kicks in at $200,000 for single filers and $250,000 for those who are married and filing jointly.
S-Corp Payroll Tax Savings
Business owners with substantial incomes can limit how much of their income is hit with payroll taxes. Employee-owners must pay themselves a reasonable salary, subject to payroll taxes. The remaining profits each year can be distributed without withholding payroll taxes. Be sure to consult with your tax professional and financial planner about what is a reasonable salary based on your income and job responsibilities.
Running an extremely low salary can help you minimize payroll taxes, but this will also reduce your eventual Social Security benefits. This shouldn’t be a huge issue if you are using the tax savings to add more to your retirement accounts like a Solo 401(k) or Cash Balance Pension Plan. On the other hand, if you are using the tax saving to spend, spend, spend, you will likely not be able to invest enough to maintain your standard of living in retirement.
Should You Increase Payroll to Increase Social Security Benefits?
There is no simple, quick, and easy answer to how much of your income you should put through payroll to have the maximum retirement income. Yes, running more income through payroll (and paying more taxes) will increase your Social Security benefits, but how much? This conversation gets more complicated if you have a spouse who also has a benefit or is self-employed.
I will say, in general, that if a married couple works together, it doesn’t usually work in your favor to pay both spouses equally. For example, if your business has $500,000 of income, you wouldn’t want each of you to take $250,000 of salary. This would mean more of your income would be hit by payroll taxes. Instead, a reasonable salary might be $100,000 for the business driver and, say, $30,000 for the second spouse who helps in a more administrative role. (Just giving an example here). The remaining $370,000 would be distributed as profits.
Higher Salaries Bring Higher Retirement Plan Contribution Limits
Another reason to take a higher salary is to allow for larger retirement plan contribution limits. For a Solo 401(k) in 2022, you can contribute $20,500 as an employee, and the employer (also you) can contribute up to 25% of your salary as a profit-sharing contribution. Business owners aged 50 or older can also make a $6,500 catch-up contribution as the employee resulting in a whopping total pre-tax contribution of $67,500. You would need a salary of at least $162,000 to make the maximum allowable Solo 401(k) contribution in 2022.
Those with even higher incomes should check out the Cash Balance Pension Plan. I ran a proposal earlier in the year where a husband-and-wife business owner team could contribute more than $700,000 between their 401(k) and Cash Balance Pension Plan. As their tax planning financial advisor, I crunched the numbers. I determined that they could reduce their federal and California income taxes if they were willing to pay a little more in payroll taxes (we raised their salaries to allow maximum contributions to retirement accounts). Remember, they only have to pay the total 15.3% payroll tax on the first $147,000 each of salary. At their income level, they were facing 37% federal and 13.3% state taxes.
Tax planning is part of running a business. It is not just how much you make but how much you keep. As your business income grows, the value of proactive tax planning grows exponentially. Some tax-minimizing strategies need to be implemented during the calendar year, so don’t procrastinate and wait until your tax-filing deadline to think about taxes.