Will Moving to an S-Corp Impact Your Overall Social Security Benefit When You Retire?
Reducing your self-employment taxes through an S-Corp can result in huge tax savings, but sometimes raises the question: does paying less in tax impact my Social Security Benefit upon retirement? The short answer is a favorite in the tax and accounting world, which is…it depends.
Background On S-Corp Wages
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?
Calculating Social Security Benefits
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 in for 10 years will qualify, since you can earn up to four credits per year. For 2021, you earn one work credit for every $1,470 in earnings, up to the maximum of four credits, or $5,880. 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 a full retirement age of 66 in 2021, the maximum monthly benefit amount is $3,113. This jumps to $3,895 for those who delay taking benefits until they reach 70.
If you’re curious to deep dive into indexes and calculating specific benefit amounts, you can read what the IRS says.
Okay, 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.
Reasons Not To Worry:
Social Security Taxes are Capped:
Social Security taxes are capped each year (when your annual salary reaches $142,800 for 2021). This means that any wages you earn over that amount are not subject to Social Security taxes. So, you are earning more money 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.
There are Better Plans Out There:
Let’s face it, the maximum monthly benefit amount from Social Security is not going to 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. Making the transition 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 $19,500 (plus a $6,500 catch-up if over 50) as the employee and an employer match of an additional 25% of compensation, up to $38,500. A SEP IRA allows contributions of 25% of total compensation or adjusted net earnings, up to $58,000. SIMPLE IRAs limit contributions to $13,500, 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.
Early Withdraw Options of Other Retirement Funds
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 the option to start drawing benefits at 62, but the maximum monthly benefit will be reduced to $2,324. 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.
Channel Your Income Into Tax-Advantaged Retirement Saving Options
Making the conversion to an S-Corp provides many benefits to the shareholder/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 having control of 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.
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