Building wealth requires a keen focus on tax management. However, finding a way to avoid tax today doesn’t always translate into greater wealth tomorrow.
One of the most popular tax avoidance strategies is for a small business owner to go from being taxed as a sole proprietor (Schedule C) to being taxed as an S Corporation. The primary driver behind this strategy is that as an S Corporation you can control your exposure to FICA (social security and Medicare) taxes through what is termed a reasonable salary.
As a Schedule C 100% of your net earnings is subject to FICA while under an S Corporation only the reasonable salary is subject to FICA.
Here is an example of the calculation to determine the FICA tax savings using a very hypothetical situation:
As you see the above example shows a clear benefit of the tax savings between the two options. Please note there are many factors that go into determining a reasonable salary, so the above example is for illustration purposes only.
We won’t go into the details of determining a reasonable salary here. Rather, the objective is to understand when utilizing an S Corporation strictly for payroll tax savings could move you from a tax avoidance strategy to a wealth avoidance strategy.
As you will learn, this strategy becomes a wealth avoidance strategy when there is a narrow focus on your desire to pay the least amount of tax.
Understanding how Social Security is calculated
To understand if your tax avoidance strategy is a wealth avoidance strategy you need to first understand how Social Security income is calculated.
As you know, FICA is a combination of Social Security and Medicare. Of these two taxes, avoiding Social Security too much is what can lead to wealth avoidance.
For your sake, I plan on keeping how it is calculated very brief since reading it can make you go cross eyed. Here is the cliff notes version of how your Social Security is calculated:
- Your historical earnings are adjusted for inflation
- The highest 35 years of earnings are the only periods included
- An average of those inflation adjusted 35 years is used to calculate Average Indexed Monthly Earnings (AIME)
- Replacement factors are then applied to AIME
- 90% replacement factor of the first $856/month (in 2016) PLUS
- 32% replacement factor of the next $4,301/month PLUS
- 15% of any remaining income of AIME
Now that you recovered from the details of the calculation from above, the point is that as AIME increases, the actual social security benefit received increases at a slower rate. Social Security effectively replaces a higher percentage of income at lower-income, and less for higher-income.
Because Social Security benefits increase at a slower rate as AIME increases, the motivation to avoid paying FICA does increase as income rises. However, by avoiding the payment of social security on a lower amount of income, you are avoiding a future income stream you could use in retirement. In other words, there is a reasonable incentive to pay at least some tax now for future money later since this is a tax you will see a direct impact from during your life.
Value of Social Security in your retirement portfolio
Now that you know how Social Security is calculated and have gained an understanding that you will receive a direct benefit later, you might be curious how to value Social Security in your retirement portfolio.
For starters, it’s good to know how much the average person relies on Social Security in retirement.
In studies completed by the Health and Retirement Study (HRS) the median household (i.e. $50,000 income under AIME) relies on Social Security income to fund 42% of their retirement. In real dollars this equates to approximately a $21,000 annual income stream in retirement.
If you’re below the median household then the study indicates Social Security replaces a higher percentage of your income, and if you’re above the household then the study indicates it replaces a lower percentage of your income. No surprises here.
With the realization that Social Security can play a major role in your retirement, it’s good to take it up a notch to understand what the value of the Social Security income stream is in real numbers. In other words, how much would I need to save separately to replace my anticipated income stream?
Building off the $21,000 income stream referenced above… you would need to have saved a total sum of $400,000 that continues growing at 3% per year to cover your 30 year retirement.
Point being, by avoiding FICA completely you might be penny-wise, pound foolish. Be cautious in the efforts taken to avoid FICA taxes, as in the long run avoiding the taxes can actually produce less long-term wealth by foregoing potentially significant Social Security Benefits.
Don’t let your tax avoidance strategy turn into a wealth avoidance strategy.
Do you want to understand how to make your money work for you and keep more of what you have earned?
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor, and all rights are reserved. Read the full Disclaimer in the footer below.