The Social Security system will begin paying out more in benefits than it receives in payroll taxes starting in 2016. The Obama administration has not yet announced its plans for plugging this gap, but any solution is likely to involve higher taxes.
Social Security taxes already are high. Working Americans pay 6.2% of their wages in Social Security payroll taxes — or 12.4% if they’re self-employed — on up to $106,800 of income. On top of that, the IRS expects many to pay income taxes on the Social Security benefits that they receive during retirement — even though taxpayers in essence already paid income taxes on this money back when they earned wages, a portion of which was diverted into the Social Security system.
Strategies for trimming Social Security payroll taxes and income tax on Social Security benefits…
Here is what some business owners — and employees who have a degree of control over when they are paid — can do to cut their Social Security payroll taxes…
Alternate high-earning years with low-earning years. Social Security payroll taxes are imposed on only a limited amount of earned income. In 2009, only the first $106,800 of income is subject to payroll tax. (This figure, called the “wage base,” increases most years with the cost of living.) Certain business owners can take advantage of this by paying themselves significantly more than the wage base in some years and significantly less in other years.
Example: An S corporation owner who ordinarily pays himself $110,000 each year instead pays himself $40,000 in 2007… $40,000 in 2008… and $250,000 this year. Because only $106,800 of that $250,000 is subject to the 12.4% Social Security payroll tax in 2009 (the combined rate paid by the owner and his corporation), he saves $14,818 in taxes compared with the three-year even distribution of pay.
Caution: By “stacking” your pay into certain years this way, you may bump a portion of your income into a higher income tax bracket or into the alternative minimum tax — exactly how much depends on your filing status, among other factors.
Tax-saver for employees: If your base pay is significantly below the annual Social Security wage base, but you receive big year-end bonuses that bring you into the vicinity of the $106,800 cap, ask your employer to postpone every other bonus from the end of one year to the beginning of the next, creating alternating double-bonus and no-bonus years. If this results in annual compensation well below the wage base in one year, but well above in the next, the overall Social Security taxes you pay will be reduced.
Married couples that work together in family businesses can allocate income unevenly between spouses. The high-earning spouse’s income won’t face payroll taxes above the Social Security wage base.
Note: This strategy makes particular sense when the low-earning partner expects to eventually claim the 50% Social Security spousal benefit rather than use his/her own Social Security earnings history to determine retirement benefits.
Example: A wife is an attorney in private practice, while her husband acts as her part-time office manager. The business earns $250,000 each year and pays $230,000 to the attorney and $20,000 to her husband. Compared with dividing the income more or less evenly between partners, this frees $123,200 (versus $36,400 if both salaries are equal) from payroll taxes, saving $10,763 per year.
Caution: The IRS might take issue if a spouse’s income is clearly far out of line with the work performed and thus a blatant attempt to dodge payroll taxes.
Family businesses can pay the business owners’ children significant salaries. Those under age 18 are not required to pay any federal payroll tax when they work for their parents, and in many states, they are exempt from state employment taxes as well.
Warning: The child’s income must be roughly appropriate for the work performed or the IRS could conclude that the parents are illegally hiding their earnings from taxation.
If your income is between $25,000 and $34,000 in a year in which you receive Social Security benefits ($32,000 and $44,000 if married and filing jointly), you must pay income tax on 50% of your Social Security benefits. If your income is more than $34,000 ($44,000 if married and filing jointly), you must pay income tax on up to 85% of your benefits.
These income thresholds refer to something called “combined income” — your adjusted gross income plus 50% of your Social Security benefits plus nontaxable interest income, such as income from municipal bonds. (For details, see IRS Publication 915, Social Security and Equivalent Railroad Retirement Benefits, available at www.irs.gov.)
Good news: Here are three ways to legally reduce or avoid Social Security benefits taxes…
Spend down your tax-deferred retirement accounts before filing for Social Security benefits. If you have lots of tax-deferred retirement savings and wish to avoid benefits taxes — and you haven’t started receiving Social Security retirement benefits — do not file for Social Security benefits until age 70. Until then, live primarily off money from your tax-deferred retirement accounts. While withdrawals are taxable income, benefits taxation thresholds are irrelevant if you’re not yet receiving benefits.
By the time you near age 70, you might have spent the lion’s share of your tax-deferred savings. But because your Social Security benefits increase by 7% or 8% per year for each year you wait to file between age 62 and age 70, your inflatedSocial Security checks — together with your non-tax-deferred savings and the remainder of your tax-deferred savings — may provide a more comfortable retirement.
Exception: Delaying the start of benefits is a bad idea if poor health or family history suggests that you might not live to your late 70s or later.
Caution: Don’t wait until age 70½ to begin making withdrawals from tax-deferred retirement plans, or IRS required distribution rules will tie your hands and force you to make withdrawals in years when they do not make sense from a tax perspective.
Avoid the midyear retirement benefits trap. If you retire in the middle of a calendar year, the income you earned during your final months in the workforce could easily push you over the threshold and make your first year’s Social Security benefits taxable. If you retire midyear, wait at least until the following calendar year to file for Social Security benefits.
Exception: Your earned income might not push you past the benefits taxation threshold if you were employed for only a few months of this final year… or had a low salary during this final year.
Relocate to a state that doesn’t tax Social Security benefits. State income taxes can exceed 8%.
Solution: Consider retiring to a state that has no state income tax… or which excludes Social Security benefits from taxation.
States that do tax Social Security benefits: Colorado, Connecticut, Iowa, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia. (Iowa and Missouri are phasing out this tax.)