Getting the most out of Social Security is all about waiting as long as possible to start filing for benefits, right?
Not quite--especially if, as a business owner, you get to decide how you are paid.
You can actually live on a lot more money in retirement if you make some changes right now to your salary and take some steps to adjust your current tax bills, says Matthew Allen, a co-founder of New York City-based Social Security Advisors.
"Self-employed people generally have more flexibility in how to structure their income," he says. "That gives you a lot of good opportunities because of the way Social Security benefits are calculated."
The main tactic that Allen lays out below isn't overwhelmingly complex: Start replacing some of your salary with dividends, as long as you have a legitimate business reason to do so. (There's no required schedule for dividends, but you may wish to take them quarterly, for regular cash flow.) Meanwhile, boost your contributions to retirement savings accounts.
It's a simple enough change--but it's not a very obvious strategy until you understand how the Social Security and income tax systems work, and how the two interact.
What your current salary means
To survive in retirement, you'll obviously have to replace some of your current wages with other sources of income, including savings or pensions or government benefits. Social Security, of course, is the nation's cornerstone retirement safety net; it provided some 50.3 million retirees and survivors, or about 15 percent of Americans, with benefits in 2016. If you're planning on relying on Social Security, you probably already know that the amount you'll get at retirement varies depending on how much you've earned and paid into the system. What is less well advertised is that Social Security's benefit formula favors lower-income retirees, the assumption being that those who haven't earned high wages don't have much in savings.
Since low-wage workers are less likely to have other sources of retirement income, Social Security's graduated benefit formula gives them the highest "wage replacement" rates. Specifically, those who earned average monthly wages of $885, or $10,620 per year, get 90 percent of those wages replaced by Social Security benefits. But the replacement rate drops as you earn more, falling to just 15 percent for those earning more than $64,000 per year.
In other words, if you earn an average of $10,620 in each of the 35 years that Social Security will use to calculate your benefits, you'll be due a monthly Social Security payment of $796.50 at normal retirement age.
But if you earn 10 times that much--and pay 10 times as much in employment taxes--your monthly benefit would increase only by 3.5 times, to $2,747.92.
Can you pay yourself dividends instead?
Here's where your current tax bill comes in. You're paying Social Security taxes only on your salary, or earned income; dividend and investment income is exempt. So, as Allen suggests, you can minimize your employment tax by paying yourself partly through dividends, rather than through regular wages.
However, because this strategy will reduce your future Social Security income, it is wise to boost contributions to your retirement plans at the same time.
Let's say your business earns you $100,000 annually, of which you contribute $10,000 to your retirement plan. If you take the rest of your earnings in wages, you'll pay roughly 33 percent in employment and income taxes. But if you take $15,000 as dividends and increase your retirement contributions by $5,000 annually--thus cutting your wages by $20,000 a year--your overall tax rate drops to roughly 27 percent, for wages and dividends combined. In both cases, your after-tax take home is around $60,000--but if you adopt the latter strategy, you'll save about $5,000 in taxes each year.
Then, when retirement rolls around, you'll get slightly less in monthly Social Security benefits--about $316 per month in this example. But you'll also have dramatically more saved for retirement: about $750,000 more, assuming a 7 percent average return over 35 years. That's enough to pay you $3,322 per month for 35 years--about $3,000 more than you "lost" in Social Security benefits.
Make your dividends count
There's one big caveat. You need legitimate reasons to pay yourself dividends, rather than simply wages, for this to pass muster with the Internal Revenue Service, says Philip J. Holthouse, partner with the Los Angeles accounting firm Holthouse Carlin & Van Trigt. Otherwise, the IRS is likely to challenge your strategy and "recharacterize" your income as wages, levying the appropriate taxes and penalties in the process. And a tax court may agree.
So what are legitimate reasons to pay yourself dividends rather than wages? When a portion of your company's profits are derived from something other than your work as a "key employee."
If you employ anyone other than yourself (and any co-owners), or if you invest in machinery or equipment that is responsible for generating a portion of your company's revenue, it's considered reasonable to take wages for your work and dividends for the profit that was derived from your other employees or company assets.
There's no set formula for determining what portion of your income should be claimed as wages versus dividends. But realize that you may have to justify whatever formula you choose, so you should have a reasonable approach. You could research competitive wages in your industry and take any excess profit over that amount as a dividend, for instance. Or if you're able to directly attribute revenue to employees--or assets--that could work too.
However, the more of the company's earnings you take as dividends versus wages, the more likely you are to be questioned by the IRS, warns Holthouse. And if you run your business full time, you always have to pay yourself at least some wages.
"The idea that you could earn no wages from a business where you work full time has been pretty universally rejected by the IRS and the courts," says Holthouse. "Otherwise, if you have an argument with economic substance, you could very well win. It gets very fact-specific."
Given that this sort of dividend-income strategy could pique IRS scrutiny if misused, you may want to consult a tax professional before adopting it.
"Social Security is essentially one big math problem layered with 2,000 different rules," says Allen. However, he adds, many couples could end up collecting around $1 million in benefits over their lifetimes: "I can't think of anything else where it's as important to get it right the first time around."