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Social Security planning for business owners – how to maximize your Social Security and avoid leaving Uncle Sam a big tip

If you are a business owner that files as a S Corporation, understanding how Social Security and its bend points function is an important step in both retirement planning and efficient tax management. This blog is geared towards small business owners that can control their W2 income and the distributions they take, but a lot of it still applies to W2 employees on how your current salary affects your Social Security paycheck in retirement. We aren’t going to go into how Social Security works, for more about that please read this blog post, but we will be discussing how business owners are able to maximize their Social Security in the most tax efficient manner.

One of the strategies that small business owners use to reduce their tax burden is to pay themselves a small salary as a W2 employee of their business and then take a large percentage of their compensation through an owner distribution. The advantage to taking a distribution as opposed to W2 income is that the owner avoids having to pay FICA taxes (Social Security & Medicare). This is able to save the business owner 15.3% in taxes because they don’t have to pay the 7.65% FICA tax as both the employee and employer (for any W2 employees still reading this, your employer pays half your FICA taxes).

Where I run into issues regarding this strategy is that the IRS expects a business owner to pay themselves a “reasonable salary” and unfortunately there is not an exact number that defines that. The guidance the IRS provides is that the salary should be what the business owner would pay a new employee with the following criteria:

“Some factors considered by the courts in determining reasonable compensation:

There is a lot of grey area in determining the right salary to pay yourself as the business owner and we won’t be able to cover that in this post (make sure to talk with your advisor and CPA for that advice). What we will talk about is planning considerations in regard to optimizing your Social Security benefit while limiting your tax obligations.

Social Security is designed to replace a larger percentage of a low-income worker’s wage in retirement than a high-income earners wage. While I can’t find anything that supports this, I think it’s a pretty safe assumption that the designers of Social Security believed that the higher income workers had the ability to save for retirement through other means (401k, IRA, etc) where a lower income individual might not have the means to do so.

Because of this, Social Security has things called bend points in how your Social Security benefit is calculated. Currently there are two bend points in your average indexed monthly earnings (AIME): $960 and $5,785 in 2020.2 While you have the ability to have unlimited earnings each year, the Social Security wage base is capped at $137,700 per year or $11,475 per month in 2020 meaning that any earnings above that amount are not subject to the Social Security portion of the FICA tax.

So, you can see there are diminishing returns in your Social Security check as your salary increases. You get the most bang for your buck if you only pay yourself $11,520, but unfortunately that likely would not fall into the “reasonable salary” category. However, capping your salary at that second bend point of $69,420 could be considered a reasonable salary. Depending on what you do and where you live, this might be a much more appropriate cap on your own salary and allows you still replace 32% of your income for Social Security purposes. Then you can take the rest of your income via an owner distribution so that you avoid paying 15.3% in FICA taxes and only getting 15% of your earning replaced by Social Security.

You can certainly pay yourself less than that second bend point, especially if your business is not super profitable, but paying yourself above that second bend point has diminishing returns. I will caveat that you should absolutely speak with your own CPA and advisor to determine what you think would be defensible as a “reasonable” salary if the IRS came knocking.

I’m absolutely not advocating anyone cheat the system just to get out of paying taxes, but I am someone that wants to use the rules of our tax system to our advantage and avoid overpaying the IRS and leaving Uncle Sam a hefty tip.

Thayer Financial, L.L.C. (“Thayer Financial”) is a registered investment adviser offering advisory services in the State of North Carolina and in other jurisdictions where exempted. All written content on this site is for information purposes only and should not be construed as advice. Opinions expressed herein are solely those of Thayer Financial, L.L.C., unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to other parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant, or legal counsel prior to implementation. This website may provide links to others for the convenience of our users. Our firm has no control over the accuracy or content of these other websites.

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