If you're considering forming an S Corporation to reduce your tax burden, you probably have a questions about your future retirement benefits. It’s not just about saving on taxes today—it’s also about building a strong financial future. Let’s break down the key points so that you can make an informed decision.
S Corp Quick Recap.
An S Corporation is a tax business structure that allows business owners to benefit from reduction of self employment taxes. Unlike a sole proprietorship, where all your whole net income is subject to self-employment taxes (which total 15.3%), an S Corp lets you pay yourself a “reasonable” salary. You can then take the remaining profits of the business as distributions, which are not subject to payroll taxes. This setup can save you a significant amount of money on your taxes.
However, while this can be an excellent tax-saving strategy, it also affects your future Social Security benefits.
S Corps: Tax Break Today, Social Security Trade-Off Tomorrow.
When you are self-employed, you are responsible for paying both the employer and employee portions of Social Security and Medicare taxes (often referred to as FICA taxes). In 2024, the total FICA tax rate is 15.3% on your income up to $168,600. This is broken down into 12.4% for Social Security and 2.9% for Medicare. Once your income surpasses the $168,600 threshold, the 12.4% Social Security tax no longer applies. However, you still pay the 2.9% Medicare tax, regardless of how much you earn.
If you’re operating as a sole proprietor all of your business net income is subject to these taxes.
But, as an S Corp owner, you can take some of your earnings as distributions. Distributions are not subject to the 15.3% payroll tax, which is where the tax savings come in.
When you take money out of your S Corp as a distribution (rather than as salary), it doesn’t count as income subject to self self employment taxes. This means that if you pay yourself a smaller salary and take the majority of your income as distributions, you won’t have as many earnings contributing to your Social Security benefits but will get an immediate tax break.
The Impact of Distributions on Your Future Social Security Benefit.
Here’s a closer look at how taking distributions from an S Corp could affect your Social Security benefits:
If you decide to pay yourself a modest salary and take a large portion of your income as distributions, you’ll be lowering your Social Security earnings. This means that in the future your Social Security monthly benefit could be lower than someone who pays themselves a higher salary.
For instance, if you pay yourself $60,000 as salary but take $40,000 as distributions, you are essentially lowering the amount of money that counts toward your Social Security earnings, even though you’ve made that $40,000 in business profits.
A Real-Life Example: Violet vs. Jane.
To help explain the impact, let’s compare two business owners: Violet and Jane.
- Violet: Violet works for 35 years, earning $100,000 every year, all of which is taxed for Social Security. Over her career, this leads to an estimated monthly Social Security benefit of about $3,039.
- Jane: Jane starts her career with an S Corp, paying herself a salary of $60,000 and taking $40,000 as distributions. Since distributions aren’t taxed for Social Security, her Social Security benefits are lower. She gets about $2,246 a month, which is $792 less than Violet—$9,510 less each year.
By taking distributions, Jane saves 15.3% in payroll taxes on the $40,000 each year, which totals $214,200 over 35 years. If Violet continues to receive Social Security benefits for 30 years when she retires, she will receive an additional $285,325.20 of Social Security income compared to Jane ($9,510 × 30 years).
Of course, one knows how much time we have on this earth, so this comparison is very approximate. There is much to consider about the present value of money, as well as the possibility that the Social Security system may not exist in the near future.
Is It Worth the Trade-Off?
For many business owners, the tax savings from an S Corp outweigh the slight reduction in Social Security benefits. The amount saved on payroll taxes is often far larger than the small decrease in Social Security payouts.
Let’s put it into perspective: saving 15.3% on $40,000 each year for 35 years adds up to significant tax savings. If you invest those savings wisely, say by contributing to retirement accounts, you could make up for the reduced Social Security benefits and potentially build a much larger nest egg for your future.
For higher earners, especially those who are focused on wealth-building, the reduced Social Security benefit may not be a major concern, especially considering how much they are saving in taxes.
So, $214,200 in tax savings over 35 years of careers VS additional $285,325 of Social Security income if you live long enough. What would be your choice?
Planning for Retirement Outside of Social Security
If you're concerned about how an S Corp could affect your Social Security benefits, don’t panic. You can make strategic use of the tax savings to plan for a more robust retirement. For instance, the money saved through the S Corp could be funneled into tax-advantaged retirement accounts, including:
- Solo 401(k): A great option for self-employed individuals, the Solo 401(k) allows you to contribute more than a traditional IRA, helping you save for retirement.
- SEP IRA: The SEP IRA is another option for business owners that allows for larger annual contributions than a regular IRA, which can boost your savings.
- Defined Benefit Plan: If you’re looking to contribute even larger amounts to your retirement fund, a Defined Benefit Plan could be an ideal choice, though it’s more complex.
By investing the money you save from payroll taxes in these retirement vehicles, you can build wealth outside of Social Security. Bonus: retirement plans are deductible on your current taxes. On top of saving on FICA taxes, you would also be deducting your retirement contributions on your taxes. Such strategy will help you maintain financial security in retirement even if your monthly Social Security check is slightly smaller than you originally expected.
Conclusion: The S Corp Advantage
How does forming an S Corp impact your Social Security benefits? While the strategy may lead to a slightly smaller Social Security payout in the future, the tax savings you gain by taking distributions instead of a full salary are often far greater. If you use those savings wisely—by investing in retirement accounts or other long-term savings—you can make up for any loss in Social Security benefits.
For many business owners, the S Corp strategy is a win-win. It allows you to save on taxes today while building a stronger retirement fund for tomorrow. By balancing the short-term tax benefits with your long-term financial goals, you can secure a prosperous future, even with slightly reduced Social Security benefits.
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