I often get questions from financial advisers who work with self-employed individuals asking if there's a way to minimize payroll taxes, which small-business owners pay at double the rate of employees, while maximizing future Social Security retirement benefits.
Kim Seymour, a financial planner with Family Wealth Planning Group in Naples, Florida, said she has a client who's 63 years old and working in the family business. The client receives a salary of about $40,000 a year.
The client’s current estimated Social Security benefit is about $1,800 per month at her full retirement age of 66 and 8 months and about $2,400 at the maximum age of 70. Her benefit is larger than any amount she would receive as a spouse while her husband is alive but less than the monthly survivor benefit she would receive if he died first.
“Would it be beneficial to increase her salary between now and her full retirement age or beyond to increase her future Social Security benefits?” Kim asked me in an email. “Is there a way I can calculate the increased benefit per $1,000 of additional salary taking into account the additional payroll taxes paid by her and the business?”
Oh, if it were only that simple.
“Without all the information and a thorough analysis, it is hard to know,” said Martha Shedden, president and co-founder of the National Association of Registered Social Security Analysts. “But considerations here are the couple’s individual life expectancies, future earnings, and if their positions in the company allow them to take advantage of a reasonable compensation analysis.”
Self-employed individuals pay both the employer and employee share of the Social Security payroll tax. For 2022, the self-employment tax rate is 15.3% on the first $147,000 of net self-employment income. The 15.3% rate is composed of 12.4% for the Social Security component and 2.9% for the Medicare tax component.
Above the $147,000 threshold, the Social Security tax component goes away but the 2.9% Medicare tax continues before rising to 3.8% at higher income levels (above $200,000 for individuals or $250,000 for married couples filing joint returns).
Individuals who go to the trouble of setting up their businesses as S corporations have more control over their income and taxes. S corp owners can be company employees. Owner-employees must pay themselves a reasonable salary for their work, which is subject to income taxes, Social Security and Medicare taxes. Owners can receive distributions from corporate profits, which are not subject to Social Security and Medicare taxes.
“If she is being paid as an employee with W2 salary rather than as a part-owner, then generally it would be to her advantage for her to raise her pay to increase her own retirement benefit,” Shedden said. “Since the husband’s benefit is the higher of the two, it is to their advantage that he delay claiming Social Security up to age 70 to maximize any potential survivor benefit for her.”
In the end, Kim’s client decided she did not want to increase her salary and pay higher taxes to create a larger future Social Security benefit. But for some small business owners with more control over their income, a complete self-employed tax and retirement analysis, or SETARA, can be eye-opening.
A SETARA analysis is available for a fee ranging from $1,200 to $1,500 at help@rssa.com, Shedden said. It offers owners of small businesses comprehensive, technology-driven strategies to identify the optimal balance of earnings, payroll taxes and Social Security benefits.
The SETARA process includes several scenarios of probable future earnings, incorporates calculations for individuals and couples, and offers future estimates of lifetime Social Security benefits. It calculates the impact of payroll taxes on each scenario to project a net lifetime estimate.
Shedden provided a case study of a married couple who own a business. Each spouse earns $250,000 per year and has the ability to control their taxable income. They plan to work five more years.
Running through various income and tax scenarios, the SETARA analysis determined that if the couple reduced their combined annual income from $500,000 to $170,000, it would save $147,250 in Social Security and Medicare tax contributions over five years while reducing their combined Social Security benefits by less than $2,000 over their lifetimes.
“The value of showing of many options and detailed numbers is that the client can then clearly see the consequences for each, including the monthly and annual amount of income,” Shedden told me in an email. “If an option is too much of a decrease in annual income, they can consider the other options.”
So the bottom line is there is no quick answer for how much payroll tax small business owners should pay to maximize their future Social Security benefits, but a complete analysis is available for a fee.
(Questions about new Social Security rules? Find the answers in Mary Beth Franklin’s new 2022 ebook at Maximizing Social Security Benefits)
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