Be careful playing around with Social Security
The columnist discusses a common practice among small-business owners to give themselves a low salary to cut taxes, but it hurts their future Social Security benefits.
Q: In 2000, our CPA convinced us to incorporate our construction business. He also said to give my husband, as president of the company, as low a salary as possible.
So he paid himself $36,000 per year. This supposedly saved us from being so heavily taxed. But it kept his salary so low that he did not pay much into Social Security.
Six years ago I began to worry about how it would affect our future Social Security benefits. I asked him to up it to $72,000 per year — closer to what we took out of the business each year. He refused. He raised it to $39,000, then $48,000.
Now we want to retire in the next few years. We’re at our full retirement age of 66. But he would draw only $2,100 per month in Social Security. I would draw half that.
What can we do to raise our Social Security at this late date? How many years longer would he have to work, if he ups his salary to $72,000, to raise his Social Security to $3,000 a month?
A: Interesting question. Our Social Security benefits are determined by an adjusted figure for a worker’s average earnings.
The final number is based on (1) the highest 35 years of income and (2) the age at which the benefits are taken.
The most effective way for your husband to increase his $2,100 benefit is to defer it. But even if he defers to age 70, it will be short of $3,000 a month.
Now let’s ask ourselves what was going on here, and why.
Your accountant was gaming the tax code. He was looking to maximize the bang for the buck in employment taxes you paid by limiting earned income. Understating work income cut your tax bill at the same time.
Basically, he was trying to maximize current after-tax income while reporting earnings that would capture a good future Social Security benefit.
Whether the accountant (and your husband) should have done this is a really long conversation. They aren’t alone: Millions of small-business owners do this, and it costs the Social Security system billions.
The incentive for reporting a lower wage income is clear: When a dollar is added to wages, the Social Security employment tax is 15.3 percent.
Add a marginal federal income-tax rate of 15 percent, and 30.3 percent is coming out of each additional dollar of income — even though actual income can be well under $80,000.
If you are fortunate enough to be in the 25 percent tax bracket (taxable income over $73,800 for a couple) the combined marginal tax rate is 40.3 percent. That’s pretty stiff.
The broad result of this, according to the Internal Revenue Service, is that billions in income is “under-taxed” according to tax law.
Copyright 2014, Universal Press Syndicate