By: W. Devin Wolf, CFP® Conventional wisdom encourages small business owners to form an S Corporation to reduce the amount of self-employment taxes they owe. The idea is to reduce your wages and pay profits out through a profit distribution that is not subject to the 15.3% (employee and employer combined) self-employment tax. For high earners with a willingness to save, I would argue this isn’t always a good strategy.
Consider this simplified scenario:
You have an Orthodontist that owns her own practice and makes $250,000. For simplicity sake, let’s assume no itemized deductions or other income, and she files her taxes Married Filing Jointly with 2 exemptions. She has structured the company’s 401(k) with a 13.8% match to maximize how much she can save each year. Her friend recommends she quits filing as a sole proprietor and becomes an S Corp to save $14,108 in self-employment taxes this year. Everyone likes paying less in taxes, but let’s look at how this really plays out. The good news is that the friend was right – she does save $14,108 in self-employment taxes. The bad news is her 401(k) match is limited to her $50k salary, so she saves $27,600 less — which also results in $7,728 more income tax owed. The astute reader realizes she still paid $7,728 less in tax in 2014 and brought home $33,980 more – so the friend was right!
However, there are three reasons why this retirement strategy may not be as good as it seems at first glance.
- Failure to Save. The additional $27,600 that was saved in the 401(k) each year equals roughly $3.4m after 35 years at a 6.5% compound annual rate of return. When a plan is set up to maximize 401(k) contributions each year, most clients stick to the plan and won’t rob from their retirement accounts for other wants and needs. The additional $33,980 in take-home income could in theory be saved in a non-qualified (taxable) account, but from a behavioral perspective, it is generally much more difficult for clients to both save the money and keep it invested.
- Loss of tax deferral. The 401(k) account has tax deferral, which essentially allows taxes in the account to be deferred until a later date. For high earners, this can significantly reduce returns. Assuming the loss of tax deferral results in a 1% reduction in the annual after-tax rate of return, saving $33,980 annually for 35 years at 5.5% actually results in having $16,816 less in the account than saving the $27,600 every year at 6.5%. Once again, the questioning observer might point out tax is still owed on the 401(k) account. Retirees are typically able to drop their tax bracket in retirement. Let’s say the orthodontist from above wants to pull out $100,000 net of taxes each year. This requires $117,647* (15% effective tax rate) from the 401(k), and $103,092 (3% effective tax rate) from the non-qualified account. At the end of the day, the reduced return from the loss of tax deferral still leaves the orthodontist with $1.7m less after 30 years of retirement.
Below is a graph depicting the scenario above.
- Loss of Social Security. Although we think of Social Security contributions as a tax, in reality, the more we contribute the more we will eventually get back. In the example of the orthodontist, by keeping her salary high she would qualify for the maximum Social Security benefit of $31,704 in 2014 at age 66. By only contributing an inflation-adjusted amount equivalent to $50,000 a year in today’s dollars, over the course of her career, I estimate she would only receive about $16,596 at age 66. To purchase an inflation-adjusted annuity equivalent to the lost $15,108 in annual income, it would cost a 66 year old female around $310,000. Social Security also offers spousal and survivor benefits that might benefit her family further.
Unwanted IRS Attention.
- The IRS requires you pay yourself a reasonable salary. In the case mentioned above, the median income for an orthodontist appears to be around $125,000, so only paying oneself a $50,000 salary might put them at risk for an audit.
Social Security Tax Savings.
- The Social Security tax wage base in 2014 is $117,000. Setting a salary at or near this level will maximize your future social security benefit, but you will also erode most of the tax savings associated with this strategy. Medicare tax is not limited to a wage base and an additional 0.9% surtax is added to income above certain limits. Very high earners may be able to structure an S Corp and their 401(k) plan to get the best of both worlds. A properly structured plan may allow the owner to contribute the maximum $52,000 ($57,500 with age 50+ catch-up contribution) and reduce Medicare taxes. For every $100,000 in income reported as a profit distribution above $250,000 a married filing jointly S Corp shareholder will save $3,800 in Medicare Tax. There may be additional costs, complexities, and advantages associated with incorporating your business which are not addressed in this analysis. Forming an S Corp (full disclosure: we actually operate as an S Corp) can be a great strategy; however, you should look beyond the immediate tax savings to see if it is right for you.