For most workers who pay into social security, their social security tax is based on 6.2% of their earned income up to the social security taxable wage base ($118,500 in 2015). For self-employed individuals however they must also pay the "employer" portion of the social security tax due, which is an additional 6.2% of the social security taxable wage base, for a total tax of 12.4%. Ouch!
Since self-employed individuals know this, they often work closely with their accountant to minimize their income subject to social security tax in order to save on as much of the 12.4% tax as possible. Unfortunately, this is a two edged sword. By minimizing their taxable income they also reduce their eligible social security retirement benefits. This is because your social security benefits are based on your highest 35 years of averaged indexed monthly earnings (AIME). Lower taxable income means lower social security taxes but also lower social security lifetime income benefits.
As self-employed individuals start to approach retirement, however, their focus on saving social security taxes often starts to shift to maximizing social retirement income benefits instead. The realization that their social security benefits may be inadequate in retirement generates many questions regarding what can or should they do to increase their benefits.
Clearly it's a trade off between paying additional social security taxes today in order to obtain higher lifetime retirement benefits. So how can you calculate if the trade off is worth it? As you might suspect, every situation is different. It will depend on what your current benefit is, what it could grow to with higher earnings, when you plan to retire, whether or not your spouse is an employee in your company, spousal (or ex-spousal) benefit options etc. This is no simple calculation and it requires sophisticated social security software but it may be worth the effort.
Let's look at an example. I was approached by a CPA who had a client who was self-employed and worked with his spouse in their business. They were in their sixties and concerned that their social security retirement benefits were too low and wanted to know what could be done. Without going into the full detailed analysis required to fully explain their options let me share some basic options available to them.
By re-allocating a large portion of her income to her husband's income we were able to save on a significant portion of the 12.4% social security tax on her income. Since his income was already above the social security wage base, taking on some of her income did not result in any additional social security tax for him. It also provided them with the same amount of household income.
In addition, since his wife was age 64, and now had minimal earned income, she was able to apply for social security benefits (slightly reduced) and not be subject to the earnings test, which would have otherwise have clawed back her social security benefits.
Since he was age 66 he had reached his full retirement age. He had planned to defer his own benefits until his age 70 however in order to increase his benefits by an additional 32%. (His benefits will grow by 8% per year guaranteed plus any cost of living adjustments). However, since his wife was now able to file for her own benefits early (at age 64) he was now eligible to file a restricted application for spousal benefits and collect 50% of her FULL benefit amount (the amount she would have been eligible for had she waited until her age 66 to file for benefits). He can receive these spousal benefits until his age 70, at which time he will switch to his own higher benefit.
So, to summarize, they were not only able to save on most of her social security taxes while continuing to receive their original total household income from their business but they were BOTH also able to start to receiving income from social security earlier than planned!
If you know the over 2,700 social security rules and have sophisticated social security planning software you may be able to identify similar strategies applicable to your own situation. If not, it may be worthwhile to work closely with a social security planning specialist, as well as your CPA, to review all your options available to you to minimize social security taxes and maximize social security retirement income. This could represent tens of thousands or even hundreds of thousands of additional income in retirement that you may otherwise leave on the table.
Ash Ahluwalia, NSSA, CCSCA, MBA