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. Tax changes allowing a 20% pass-through tax deduction until 2025 will also change this scenario. Contributing to your retirement plan will reduce your qualified business income, thus reducing the deduction. W2 wages will also reduce your business income and reduce the deduction.

Consider this simplified scenario:

You have an Orthodontist that owns her own practice and makes $275,000. For simplicity sake, let’s assume she takes the $24,000 standard deduction and files her taxes Married Filing Jointly.  She has structured the company’s 401(k) with a 13.3% match to maximize how much she can save each year. Her tax-savvy friend recommends  she quits filing as a sole proprietor and becomes an S Corp to save $16,472 in self-employment taxes this year. Everyone likes paying less in taxes, but let’s look at how this really plays out.

Column 1 Sole Prop   S corp Difference
Orthodontist Salary $275,000 $50,000
Profit Distribution $225,000
401(k) Contribution $18,500 $18,500
401(k) Employer Match (13.3%) $36,500 $6,650 $29,850
Employer’s Portion of Self-Employment Tax $12,061 $3,825
Pass Through Deduction (20% of net) $41,588 $39,205
Taxable Income $142,351 $182,820
Social Security Tax $15,922 $6,200 $9,722
Medicare Tax $8,200 $1,450 $6,750
Total Self-Employment Taxes $24,122 $7,650 $16,472
Income Taxes $23,196 $32,456 $9,260
Total Taxes Paid $47,318 $40,106 $7,212
Total Tax Deferred Savings $55,000 $25,150 $29,850
Total Household Inflow $172,682 $209,744 $37,062
Annual Social Security Received at FRA $32,244 $17,100 $15,144

*Ignores Required Minimum Distributions (RMDs), which may accelerate how much needs to be withdrawn from the account.

The good news is that her friend was right – she does save $16,472 in self-employment taxes. The bad news is her 401(k) match is limited to her $50k salary, so she saves $48,350 less — which also results in $12,516 more income tax owed. The astute reader realizes she still paid $3,956 less in tax in 2018 and brought home $52,306 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.

  1. Failure to Save. The additional $48,350 that was saved in the 401(k) each year equals roughly $6m 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 $52,306 in take-home income could in theory be saved in a non-qualified (taxable) account, but from a  , it is generally much more difficult for clients to both save the money and keep it invested.
  2. 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 $52,306 annually for 35 years at 5.5% actually results in having $753,329 less in the account than saving the $48,350 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 $7.1m less after 30 years of retirement.

Below is a graph depicting the scenario above.

3. 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 $32,244 in 2018 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 she would only receive about $17,100 (estimated) at age 66. To purchase an inflation-adjusted annuity equivalent to the lost $15,144 in annual income, it would cost a 66-year-old female around $320,000. Social Security also offers spousal and survivor benefits that might benefit her family further.

Other considerations:

Unwanted IRS Attention.

    1. The IRS requires you to 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.

    1. The Social Security tax wage base in 2018 is $128,400. 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 $55,000 ($61,000 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.

W. Devin Wolf, CFP®