As a reminder, a key advantage of being an S-Corp is that you pay yourself a W2 wage of “reasonable compensation” (and not a penny more) to maximize your tax savings. You pay self-employment taxes as both the employer and employee on that portion of your compensation, but the remainder of your compensation (that you withdraw from the profits) are not subject to self-employment tax (hooray!).
So, what are self-employment taxes? Self-employment taxes are both the employer and employee portion of Social Security and Medicare taxes. You, as the employee, pay 7.65% of your gross wages through paycheck withholdings. Then, as the employer, you pay an additional 7.65% towards Social Security and Medicare as a payroll tax expense.
One of the benefits of being an S-Corp owner is that you reduce the overall self-employment taxes you pay since only your salary is subject to self-employment taxes, rather than your entire profit. Now, you may be wondering if there is a downside to reducing these taxes. Social Security taxes are what largely funds our Social Security system, and your earnings and tax payments are used to calculate your Social Security retirement benefits. Will reducing the self-employment taxes you pay impact your overall Social Security benefit when you retire?
Curious how the amount of your Social Security benefits are calculated? Buckle up, as this next section could be a bit of a bumpy ride (you have our permission to skip to the next section). It starts with qualification. You qualify to draw Social Security benefits by earning credits when you work and pay Social Security taxes. To draw Social Security, you must have worked and paid Social Security taxes for a certain length of time to earn a minimum of 40 credits. Generally, those who work and pay for 10 years will qualify since you can earn up to four credits per year. For 2023, you earn one work credit for every $1,640 in earnings, up to the maximum of four credits, or $6,560. This amount increases each year as your average earning level increases.
Once you qualify, the Social Security Administration (SSA) calculates your eventual Social Security benefits using your reported lifetime wages (aka, your W2 income). The SSA indexes the reported earnings to adjust for value changes due to the passing of time. They take the average indexed earnings by the month for the 35 years that you worked and earned the most and apply a formula to determine your basic benefit amount. For someone at the retirement age of 67 (or 66 for those born between 1943 to 1954), the maximum monthly benefit amount is $3,627 in 2023. This jumps to $4,555 for those who delay taking benefits until they reach 70. Conversely, if you retire at 62, your maximum benefit reduces to $2,572.
Now that you know what to do to qualify and how your benefit is determined, you can see that the simple answer is yes: reducing self-employment taxes may impact your overall Social Security benefit amount. However, what really matters is “how much” your benefit is impacted. You should consider other variables when weighing the benefits of reducing your overall self-employment taxes compared to maximizing your future benefits.
Social Security taxes are capped yearly (when your annual salary reaches $168,600 for 2024). This means that any wages you earn over that amount are not subject to Social Security taxes. So, you are earning more but not seeing any increase in your future benefit amount. If you are just an LLC, all your profits are subject to self-employment taxes with the same cap. A successful business will exceed this overall net profit and lose out on any increase in retirement benefits through Social Security.
Let’s face it: the maximum monthly benefit amount from Social Security will not be enough to cover basic living expenses for a large part of the population. This means you are going to need some form of supplementary retirement savings. Transitioning to an S-Corp increases the various retirement accounts available to you. In addition to the traditional IRA and the ROTH IRA, S-Corp owners can also open a SEP IRA, a SIMPLE IRA, a Solo 401(k), or even a Defined Benefit plan. To learn more about the best choices for you, speak to your financial advisor about the rate of return from SSA compared to other retirement investment vehicles.
The Solo 401(k) allows contributions up to $23,000 (plus a $7,500 catch-up if over 50) for 2024, as the employee and an employer match of an additional 25% of compensation, up to $46,000. A SEP IRA allows contributions of 25% of total compensation or adjusted net earnings up to $68,000 for 2024. SIMPLE IRAs limit contributions to $16,000 in 2024, with a catch-up of $3,000. Funding one of these retirement options allows you to have control of your money. Another benefit you gain is the ability to earn interest on your investment. You do not earn any interest on the funds you pay into Social Security.
You will not qualify for your full Social Security benefit amount until you reach the age of 66 (67 if born after 1960). There is an option to start drawing benefits at 62, but the maximum monthly benefit will be reduced to $2572 (as of 2024). And that assumes you maxed out your earnings for each of the thirty-five years used to calculate your benefit. But funding your own retirement through your business allows you more flexibility. You can begin withdrawing funds from a SIMPLE IRA, SEP IRA, or your Solo 401(k) starting at 59 ½ without paying any penalties.
provides many benefits to the owner. You will pay less in taxes. The employer side of self-employment taxes, as well as the salary you pay yourself, are allowable business expenses, which further reduces your overall profit, thereby reducing your overall federal income tax liability. More options are available for retirement accounts as an S-Corp owner. And you can earn interest on your investments while controlling where your money goes and when you can access it. And any tax savings can provide you with a greater margin of profit to fund continued operations.
Offset those benefits with the potential impact of possibly reducing your Social Security benefit amount, which does not allow you to earn interest on your money, limits when you can draw the funds, and is most likely not going to be sufficient to cover your basic living expenses.
If you are still concerned about funding your social security benefit, your Formations team can design your payroll with this in mind. You may save less in taxes, but we can set things up to ensure you are maximizing your social security. Everything depends on your specific situation and your overall goals, for your company and your future. Give us a call today and we can discuss all your options.