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Retirement is a journey. Getting where you want to go requires a plan.
Business owners often wonder how much they should pay themselves in salary as it pertains to their social security benefits. At its core, the question is about the return on investment a business owner might receive in exchange for paying self-employment taxes.
These self-employment (SE) taxes are not inconsequential. Business owners pay both the employee’s and the employer’s share of Social Security and Medicare taxes. Social Security taxes are 12.4% on salary up to $132,900 in 2019. Medicare taxes are 2.9% on all salary, with an additional 0.9% on salary over $250,000 for married couples. It definitely pays to minimize Medicare taxes because benefits do not increase with the payment of higher taxes.
Once you’ve paid a minimal amount into Medicare for 10 years, both you and your spouse qualify for free Part A starting at age 65. (Everyone over 65 qualifies Part B as long as they pay the monthly premiums.
Our hypothetical couple, Jerry and Jamie, are both 55 years old. Jerry has paid himself the maximum Social Security wage base since he was 30. Jamie has drawn no salary at all.
If Jerry continues to pay himself the Social Security wage base until he is 66, his primary insurance amount (PIA), or the benefit he will receive if he files for it at full retirement age, will be $2,824 in today’s dollars, according to the SSA Detailed Calculator. If Jamie reaches full retirement age (FRA) with no earnings record of her own, she will be entitled to a spousal benefit of 50% of Jerry’s PIA, or $1,412. Their combined benefit at full retirement age will be $4,236.
This example can shed some light on the question of whether Jerry’s self-employment taxes on his own salary will pay off in higher Social Security benefits. At age 55, he already has 25 years of maximum earnings. If he has no further earnings, he will receive $2,443 at his full retirement age. If he works another 10 years at maximum salary, he’ll receive $2,824 at FRA, an additional $381 per month. This will cost him $170,000 in self-employment taxes.
How long will it take to make up that $170,000 in taxes? A long time. By dividing $170,000 by $381, we see that it will take 446 months, or 37 years, to break even. This means Jerry (or Jamie, as his surviving spouse) would have to live to age 103 in order for that last ten years of self- employment taxes to pay off in higher lifetime benefits.
As for the main business owner, the payment of SE taxes provides diminishing returns over time. That’s because the last tier of earnings is multiplied by only 15% in the PIA formula.
In Jerry’s case, that last ten years of salary cost him $170,000 in SE taxes and netted him only $381 in additional monthly benefits. Perhaps that $170,000 could be better invested elsewhere. This is not to say that Social Security is a bad deal from the get-go. It’s only at the high salary levels that we see diminishing returns. It would be good to determine that point of diminishing returns where it makes sense for the business owner to stop paying himself a salary after he has already qualified for a relatively high Social Security benefit. However, this really requires customized inputs for the client’s individual situation.
*Safe Harbor Retirement Planning does not provide legal or tax services. You should consult a legal or tax professional regarding your individual situation.
Mark Singer, CFP® lives in Swampscott and has been in the financial industry for over three decades. If you have any questions contact him at 781.599.2660 or firstname.lastname@example.org. The content was developed in conjunction with Elaine Floyd, CFP®.