Over at Bogelheads we read the following discussion:
Employer taxes, salaries, and 401Ks for my S-Corp
by rghost » Mon Jan 27, 2014 9:57 pm
My question is on tax strategy as I set myself up on payroll for 2014 in an S-Corp. My tax guy is just a tax guy, so before I hire an expensive accountant I hope your can provide insight:
I have a business I set up as an S-corp versus an LLC. I use ADP payroll company to pay myself a reasonable salary.
My understanding is I have two options:
1) Pay a higher salary (i.e 60K) which allows me to put more money into 401K retirement (due to the 25% employer match allowed), but then I have to pay the employer taxes which is gone forever. It looks like these are about 8% of the salary (this is employer only of course, NOT the employee (my) share)
2) Pay a lower salary, (i.e 45K) and save on these employer taxes, but then I have a lower amount I can match into retirement. Less money to build over time in the 401K, but more money upfront. Here I avoid employer taxes, but less goes into the future earnings potential of the 401K.
Assuming I am understanding this correctly,my question is on strategy here and math I am not smart enough to do. Is it generally more advisable to keep the cash right now, and liquid, or eat the taxes now and plop it in a 401K?
In these examples using 45K and 60K, it would be about $1,200 saved in taxes to pay myself the lower salary but $3750 less in the 401K. (obviously in the end the IRS gets their share when i withdraw on that money, so this is why i dont know)
ON one hand it seems like its more money for later, BUT when you account for inflation - a dollar today is worth more and the fact i will be taxed later anyway, and the fact I always hear AVOID AVOID AVOID taxes at all costs, I am not sure what the best strategy is.
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Re: Employer taxes, salaries, and 401Ks for my S-Corp
by Spirit Rider » Mon Jan 27, 2014 11:06 pm
You are saving 15.3% (7.65% on both employer/employee FICA) on the lower W2 salary.
However, if your salary numbers are accurate, you are transacting the second bend point ($4917/month in 2014) on the SS PIA calculation. If this is/will be representative the average of your 35 highest wage adjusted years (AIME), you could be reducing your ultimate SS benefit by 32% of your earnings difference.
So when you factor in lower retirement contribution (401k), you also have to factor in lower SS earnings against the savings of the lower FICA costs.
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Re: Employer taxes, salaries, and 401Ks for my S-Corp
by rghost » Tue Jan 28, 2014 12:27 am
Spirit Rider wrote:You are saving 15.3% (7.65% on both employer/employee FICA) on the lower W2 salary.
However, if your salary numbers are accurate, you are transacting the second bend point ($4917/month in 2014) on the SS PIA calculation. If this is/will be representative the average of your 35 highest wage adjusted years (AIME), you could be reducing your ultimate SS benefit by 32% of your earnings difference.
So when you factor in lower retirement contribution (401k), you also have to factor in lower SS earnings against the savings of the lower FICA costs.
Thank you I did not even consider SS calculations. You just made it that much more complicated, haha.
My average 35 year salary will likely be much higher I presume. I am in the 28% bracket once I factor in my profit distributions over and above my salary. It sounds like you would lean toward higher salary and more savings? Can you please explain bend point in laymans term, the SSA website made no sense to me.
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Re: Employer taxes, salaries, and 401Ks for my S-Corp
by SeattleCPA » Tue Jan 28, 2014 12:33 am
Here's my blog post on this issue: http://evergreensmallbusiness.com/pensi ... oll-taxes/
But the general rule is, if you're paying a 15.3% "load"' (the Social Security) to get a tax deferral, you're probably not really saving money.
Note: If you could pay zero social security tax and then invest that money yourself, you'd end up in way, way better shape...
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Re: Employer taxes, salaries, and 401Ks for my S-Corp
by Spirit Rider » Tue Jan 28, 2014 12:58 am
rghost wrote:Thank you I did not even consider SS calculations. You just made it that much more complicated, haha.
My average 35 year salary will likely be much higher I presume. I am in the 28% bracket once I factor in my profit distributions over and above my salary. It sounds like you would lean toward higher salary and more savings? Can you please explain bend point in laymans term, the SSA website made no sense to me.
SS taxes are a flat rate up to the max wage base. However, the benefits are progressive to give low wage earners a better return. The SS Primary Insurance Amount (PIA) is calculated from your Average Indexed Monthly Earnings (AIME) limited to the best 35 years. The bend points come into effect when calculating the PIA from the AIME. You receive 90% up to the first bend point, 32% from the first to the second bend point and 15% above the second bend point.
So if your AIME will end up being above the second bend point, you will receive a marginal 15% on increases to the AIME. Think of it like inverse tax brackets. So you will pay 15.3% FICA and get 15% in benefit earnings. Also, your SS earnings will only increase at the rate of the wage index. So there may be an opportunity cost that the money invested elsewhere may give a greater return. However, that will be in taxable because you have also restricted your profit sharing contributions.
It is all very complicated and I think I remember someone doing a spreadsheet to calculate the math. The main point I am making is don't let a myopic view of minimizing the FICA tax drive your S-Corp W2 salary to the detriment of your future SS benefit and profit sharing contributions.
Just remember, your increased profit sharing contributions save you more tax dollars (28% vs. 15.3%) and also gets you increased SS benefit. Personally, I think getting what retirement plan contributions you want is more important than minimizing your FICA taxes.
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Re: Employer taxes, salaries, and 401Ks for my S-Corp
by SeattleCPA » Tue Jan 28, 2014 10:36 am
Spirit Rider wrote:Just remember, your increased profit sharing contributions save you more tax dollars (28% vs. 15.3%) and also gets you increased SS benefit. Personally, I think getting what retirement plan contributions you want is more important than minimizing your FICA taxes.
OK, I agree that Spirit Riders points that you consider the SS benefits and also that you do the math. But I will observe that the case often is, bumping earned income to bump pension contributions doesn't work out.
To dig a little deeper into the weeds on this point...
The 15.3% mentioned above is a tax you can avoid permanently. So that's truly savings. And note this savings applies to all the income you characterize as wages.
But the 28% is not true saving. It's a deferral. You probably will have to pay that tax or some chunk of it someday in the future. And you're only able to defer taxes on some of the income you characterize as wages typically.
Using rough numbers, assume you're thinking about bumping your wages by $20K so you can pay a 25% match on that increment. That'll mean an extra $5K in your 401(k).
But what you're doing is paying (roughly) an extra 15% on the entire $20K or $3000 in payroll taxes so you can defer (delay) paying that 28% tax on that $5000 deferral. That'll be about $1400.
Note that when withdraw the $5000 later on, you'll need to pay tax then. Probably that'll get paid at a lower rate. Say it'll be 15%... so only $750.
But look at what happens. You've paid $3000 up front to delay paying that $1400 of income taxes ... and then don't forget about the $750 you'll pay in end.
Ignoring incremental SS benefits (which are real but small) and time value of money (which is also real but smaller in this case than you realize), you may be paying $3K or so to gain net savings of $600 to $700... 
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Re: Employer taxes, salaries, and 401Ks for my S-Corp
by Spirit Rider » Tue Jan 28, 2014 12:56 pm
SeattleCPA wrote:The 15.3% mentioned above is a tax you can avoid permanently. So that's truly savings. And note this savings applies to all the income you characterize as wages.
But, you are also permanently giving up 15% or 32% (depending on final AIME) credits for your future SS benefit.
Also, you are not really paying 15.3%. because the employer portion is a corporate expense and is deductible. So at a 28% marginal rate the employer FICA portion is 5.51% net and therefore the total FICA is an 13.16% effective rate.
I still maintain that for anyone who is in a position to use the additional W2 income to generate increased profit sharing dollars to increase their tax deferred investments, which will decrease their taxable income and purchase a deferred annuity that has a guaranteed return of the CPI-W until age 60 and then inflation protected by the CPI-U (increased SS benefits).
The minimize W2 wages in S-Corps at all cost is a myth. All myths have a basis in some reality. However, they are seldom updated to new realities, they also do not take into account the individual circumstances.
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Re: Employer taxes, salaries, and 401Ks for my S-Corp
by rghost » Tue Jan 28, 2014 1:03 pm
This is an excellent discussion thanks. The SS thing I never considered. But at 41, i keep hearing by the time I am old enough it wont even be available. That the system is broken. I don't want to open up a can of worms here, but is SS benefits still a valid consideration? In other words, on top of the explanation above, this uncertainty has me lean towards the lower salary anyway.
BTW speaking of salary, I also learned from the Bureau of Labor statistics that I am under paying myself (went there on a tip from seattle CPA's blog). NOT good. So to be IRS audit safe, I need to bump my salary to $58,620K or more.
Also, this website was excellent in explaining strategies to me so credit where due: http://drdebit.com/22.htm.
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Re: Employer taxes, salaries, and 401Ks for my S-Corp
by Spirit Rider » Tue Jan 28, 2014 1:44 pm
rghost wrote:This is an excellent discussion thanks. The SS thing I never considered. But at 41, i keep hearing by the time I am old enough it wont even be available. That the system is broken. I don't want to open up a can of worms here, but is SS benefits still a valid consideration? In other words, on top of the explanation above, this uncertainty has me lean towards the lower salary anyway.
BTW speaking of salary, I also learned from the Bureau of Labor statistics that I am under paying myself (went there on a tip from seattle CPA's blog). NOT good. So to be IRS audit safe, I need to bump my salary to $58,620K or more.
Also, this website was excellent in explaining strategies to me so credit where due: http://drdebit.com/22.htm.
Your first paragraph is entering territory not allowed on the forum. To give a simple answer an leave it at that to avoid lock. It isn't a question of whether SS will be there or not, but what will be needed to make it solvent. Some combination of increased revenue, deferred benefits (younger workers), or reduced benefits (most likely reduced COL), will be required. I wouldn't worry about it not being there.
The key things the IRS considers are how much of your revenue fall into these buckets (personal services, generated by employees, and return on capital). From the tax court rulings, you want to be careful to a start at a reasonable (40%-60%) proportion of your net profit paid as salary if all you are providing is personal services. Then factor in competitive salary analysis and any other issues specific to your circumstances that might adjust this.
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Re: Employer taxes, salaries, and 401Ks for my S-Corp
by SeattleCPA » Tue Jan 28, 2014 2:22 pm
So here's an example calculation that maybe doesn't definitely prove my point but at least explains why I'm saying what I'm saying...
Say you for some strange reason had the choice to characterize $50,000 of income as either earnings or unearned income.... would it really make sense to pay the FICA?
I don't think it would.
With $50,000 of earnings, you'd owe about $7K of self employment taxes.
As Spirit Rider notes, you get a tax deduction for the employer's portion... so figure that (in this example) as worth $500 roughly.
So social security in this case means taxpayer incurs a net cost of $6500 aftertax... roughly.
Social security isn't only a retirement benefit though,,, so let's say you want to buy some term life insurance to replace its survivors benefits feature. And say you want to buy some (and that you can buy some) long term disability to replace the disability benefits feature. And say all of that costs $1K a year.
So in end taxpayer "pays" maybe $5500 a year for that retirement benefit stream.
When I do the calculations, I think this person ends up with maybe $19K of SSI benefits at full retirement.
But if I calculate the FV of four decade stream of $5500-a-year investments, I get a FV of around $670,000 using a five percent real rate of return. (E.g., I can use this formula in Excel: =FV(0.05,40,-5500 to return that result).
So to me, the question is, what's worth more? That $670K or that $18K or $19K a year...
I think I can get more income... and in end probably leave my heirs money by "opting" out of Social Security...
BTW, if you work the numbers at $20K a year of income, I think Social Security works better... Also, if you work the numbers at $100K of income, the case for opting out looks overpowering. (This is effect of those different bands of replacement income percentages the SS formula uses.)