How do you find the optimal balance of earnings, payroll taxes and Social Security benefits?
by Martha Sheddon, RSSA, CRPC & Melissa Warren, RSSAMs. Sheddon is President and Co-founder of the National Association of Registered Social Security Analysts, NARSSA. Ms. Warren is Director of Strategic Partnerships at NARSSA. Visit https://www.narssa.org.
The Self-Employed Tax And Retirement Analysis (SETARA) is a Social Security based analysis for self-employed (SE) business owners who are in their 50s, approaching retirement age, and continuing to work.
Many already have 35 high years of earnings, which are used in their Social Security benefit calculation. Therefore, continuing to take a high salary – and pay the high SE taxes – will not significantly increase their eventual benefit amount.
The core of this topic hinges on the IRS reasonable compensation that self-employed individuals must pay themselves.
Sometimes, depending on their role in the company, SE-taxed compensation can be lowered, while increasing non-taxed distributions of profits.
The analysis projects and compares future different levels of compensation, the amount of SE tax paid on that income, and the resulting effects on the client’s Social Security benefits, including any dependents, such as their spouse.
NOTE: This article refers to Registered Social Security Analysts (RSSA). The National Association of Registered Social Security Analysts (NARSSA) educates and trains financial, tax, insurance, and other retirement professionals on the intricacies of Social Security rules and claiming option analyses to help their clients, assuring that each is making the most optimal claiming decision and receiving all the benefits they are entitled to. This type of education and training is critical to running a Self-Employed Retirement and Tax Analysis.
The Opportunity for Financial, Tax, and Insurance Professionals
As workers approach retirement age, questions about the stability and longevity of their finances during retirement and the vision they have for those years become more pressing. For many, examining the various sources of income they can rely on starts with consideration of their Social Security benefits.
Over their working years, most self-employed individuals have a certain amount of control over the salary they have earned, the deductions and depreciations on those earnings, and the resulting self-employment and income tax liabilities from those decisions.
An emerging type of analysis is finding its way to the market, which helps self-employed individuals, especially those with S Corporations, to predict what their eventual Social Security benefit will be depending on how long they continue to work and the income they will collect during those years.
Self-Employed Tax and Retirement Analysis, SETARA
A Self-Employed Tax and Retirement Analysis offers owners of small businesses a comprehensive technology-driven analysis which encompasses strategies to identify the optimal balance of earnings, payroll taxes, and Social Security benefits.
By understanding Social Security filing strategies and optimizing payroll taxes following IRS reasonable compensation guidelines, a person could save thousands of dollars annually. This can help bridge retirement income gaps, fund retirement accounts, acquire annuities, obtain life insurance, and other desired expenses.
Most Americans do not understand how their Social Security benefit is calculated, so they are not thinking of their final years of earnings in terms of how their income will affect the amount of Social Security they receive. With the S Corp business structure as an example though, they may take advantage of the option to receive distributions and modify their actual taxed wages.
Once workers reach this point in their working life, many have accumulated the 35 years of earnings used to calculate their benefit. Based on their past earnings and remaining years of projected income, Social Security benefits can be predicted quite accurately five or ten years prior to reaching full retirement age.
Financial professionals can help their self-employed business owner clients answer the question, do the extra years of earnings, and possible increase in their ultimate Social Security benefit amount, outweigh the additional years of self-employment taxes paid on those earnings?
Case Study: Max and Emma Jones
Max Jones was born in 1965 and will be 58 in 2023. He is an entrepreneur and first became a high earner in his mid-twenties. He currently owns a business, structured as a S Corp, developing technology to rid the oceans and other waterways of microplastics. His Social Security earnings history shows income at or above the maximum taxable earnings for many of the past 35 years.
Emma Jones, born in 1970, will be 53 in 2023. She earned sporadically throughout her life, choosing to work primarily in their home, raising their children. Her earnings record indicates that her estimated primary insurance amount (PIA) is $810. Her spousal benefit, based on Max’s earnings, will most likely be the higher of her benefits. Her maximum life expectancy of 90 is five years older than Max’s at 85, so future survivor benefits will also be a focus of their decision.
The first step in a Self-Employed Tax and Retirement Analysis is to evaluate the possible Social Security claiming age options. This couple has the resources for Max to wait to claim his Social Security benefit at age 70. Emma could file at the same time to receive a reduced benefit at age 65, but she will wait until her full retirement age (FRA) of 67 to receive the maximum spousal benefit. These claiming ages were also found to be the most tax-advantaged choice for this couple.
Now that he is in his late fifties, Max is thinking about possibly retiring or working part-time. The primary question is, if he continues to work for another nine years, will Max’s earnings significantly increase his Social Security benefit? And how much self-employment taxes he will pay on those earnings, compared to the resulting increase in his benefits?
Projected Salary Options
Max anticipates fully retiring in December 2031. In Figure 1, four projected earnings options are outlined:
Option A: Max will continue to make the maximum taxable earnings for 2023 through 2031. This will be considered the baseline for comparison.
Option B: Max will continue to work almost full-time and reduce his 2023 salary to $100,000.
Option C: Max will cut back to part-time work and allow his employees to take over his major responsibilities. His reduced salary is $50,000 in 2023.
Option D: Max retires now and has no more taxable earnings after 2022.
Figure 1: Max’s Projected Earnings
The Social Security Analysis
The RSSA Roadmap software analysis examines all possible retirement and spousal benefit filing dates. This assures that no benefits will be missed and breaks down all benefits a person receives by type. Lifetime benefit amounts are calculated as net present value.
Figure 2 shows a comparison of Social Security income results from RSSA Roadmap analyses for the earnings options that Max is considering.
Figure 2: Max and Emma Social Security Comparisons
If Max continues to earn the maximum taxable earnings or higher as shown in Option A, the Jones’ cumulative lifetime Social Security income will be $1,264,587, with an annual benefit of $78,637.
If Max decreases his annual wages to $100,000, Option B, their cumulative lifetime Social Security income decreases to $1,212,322, with an annual benefit of $75,387. This is a decrease of $3,250 per year or $270 per month.
If Max decreases his annual wages to $50,000, Option C, their cumulative lifetime Social Security income decreases to $1,207,176, with an annual benefit of $75,067. This is a decrease of $3,570 per year or $298 per month.
Now notice the (lack of) differences between Options C and D. Whether Max continues to earn a part-time salary of $50,000 or if he has no further earnings, his Social Security will be the same.
Due to Max’s lifetime high earnings, his PIA is nearly at the maximum possible. There is an increase in the family Social Security amounts if he continues to make $100,000 or more, but is it significant in relationship to the self-employment taxes he will pay during those years?
This brings us to the second part of the Jones’ SETARA. What will Max pay in self-employment taxes for Social Security and Medicare based on these projected earnings for the next nine years?
Self-employment taxes include both Social Security and Medicare taxes. A self-employed individual is responsible for both employee and employer portions of these contributions, totaling at 15.3% taxation on income up to the maximum taxable earnings limit.
Figure 3 shows the taxes to be paid based on future nominal dollars for Options A, B, and C. As we saw above, if Max were to retire from work, Option D, he would have no further earnings after 2022 and not pay any self-employment taxes.
Figure 3: Max’s Projected Self-Employment Taxes
The earnings for Option A are set to increase with the anticipated maximum table earnings from 2023 at an assumed annual rate of 5.5%. This ensures that Max will pay taxes on the inflation and cost of living (COLA) adjustment value of this rising benchmark.
The total self-employment taxes paid for Option A over the nine years is $275,898.
The earnings for Options B and C are shown as nominal future dollars with a 2.25% increase for the assumed inflation rate.
The total self-employment taxes paid for Option B is $150,766 and for Option C it is $75,383.
How do these nine years of self-employment tax “costs” compare to the increase, if any, in cumulative lifetime and annual Social Security income for Max and Emma?
Social Security Income vs. Self-Employment Tax Costs
Figure 4 shows the SETARA result summary for Max and Emma.
Figure 4: Max and Emma SETARA Results
Options B, C, and D are compared against the baseline, Option A, of Social Security lifetime and annual retirement income versus self-employment taxes paid.
The net increase for each option is shown in the right column. This is found by subtracting the lifetime loss of Social Security from the self-employment tax savings achieved.
Since lifetime Social Security income is shown as the net present value of future benefits and is dependent on life expectancy, the annual amount of Social Security income is another way to compare the value.
For instance, as shown in Option B, is it worth it for Max and Emma to receive a lifelong decrease of $3,250 per year, or $270 per month, if they will see a savings of $125,132 in self-employment taxes over the next nine years?
It would take over 38 years for the decreased Social Security (in today’s dollars) to equal the amount of tax savings in those nine years.
Using the same comparison for Option C, the Social Security decrease is $3,570 per year or $298 per month compared to a savings of $200,515 in self-employment taxes.
In Option D, if Max were to not receive a salary, the same lower Social Security of $3,570 per year or $298 per month is compared to even greater savings of $275,898 in self-employment taxes.
The elephant in the room is Max’s lower – or lack of – salary for the next nine years. Are the lower salaries “reasonable compensation” for the level and amount of work he is contributing to his company? Is he able to take company distributions to supplement his lower salary?
These, and many other considerations, must be examined to determine the path forward. The understanding and comparison of all the numbers is crucial information to help with that decision.
This case illustrates the tremendous opportunity financial professionals who are also a Registered Social Security Analyst, RSSA, have: to help their self-employed clients examine and plan for the years of work prior to retirement.
You can imagine the number of alternative analyses that an RSSA could assess for their clients. The ability to show these comparisons is powerful knowledge and provides precise numbers to help workers make those decisions as they near retirement.
The decisions of when to quit working and when to claim Social Security benefits cannot be made in a vacuum, so many other aspects of a worker’s finances are involved. It is a strong start on the retirement planning path.
This article explains the opportunity for financial, tax, and insurance professionals to help their self-employed clients who are nearing retirement age. A Self-Employed Tax and Retirement Analysis, SETARA, compares potential future earnings and self-employment tax costs to future Social Security benefit amounts to assist with client retirement financial decisions.
This type of service begins with a Social Security analysis, so it is critical for advisors to have a complete understanding of the Social Security rules and considerations which apply to each client. Then, the service extends to the examination of alternative projected earnings for a variable number of years and the associated self-employment tax costs.
Depending on the business structure that the self-employed individual is operating under, the software analysis can be an effective tool for comparing net income amounts, tax liabilities, and the ultimate Social Security benefits to be received.