If you work in a job covered by Social Security, you pay Social Security payroll taxes on your earnings (your tax is matched by your employer). If you are self-employed, you pay a self-employment tax. These taxes finance Social Security benefits, including retirement, survivor’s, disability, and Medicare. Like many people, you might get more back in benefits than you pay in Social Security taxes, but not necessarily. For example, you may never need to use all of the benefits you’re entitled to, or you may be entitled to a greater benefit based on someone else’s earnings record. If you think that you will contribute much more in payroll taxes than you will receive in benefits, you can try to minimize the Social Security taxes you pay.
Understanding how Social Security Payroll Taxes and Self-Employment Taxes Finance Your Benefits
If you work in covered employment, Social Security payroll taxes are paid by both you and your employer
When you work for an employer, you pay a tax to finance Social Security benefit programs. This tax is called FICA (Federal Insurance Contributions Act), and your employer deducts the tax directly from your paycheck. For each contribution you make, your employer contributes an equal amount.
If you’re self-employed, you pay a self-employment tax on your earnings
If you’re self-employed, you’re both the employer and the employee of your business, so you’re required to pay a self-employment tax equal to the combined amount of payroll taxes employers and employees pay. You pay this tax when you file your annual tax return with the IRS or in estimated tax payments throughout the year.
The Social Security Administration (SSA) distributes your taxes to three funds
The taxes you pay are distributed to the three trust funds that pay benefits: the Old-Age and Survivors Insurance Trust Fund (OAS), the Federal Disability Insurance Trust Fund (DI), and the Federal Hospital Insurance Trust Fund (HI). Even though you contribute to three funds, the OAS and the DI are combined for taxation purposes. The resulting OASDI tax pays retirement (old-age), survivor’s, and disability benefits, while the HI pays Medicare benefits.
How much tax do you pay?
When you work for an employer—If you’re an employee who works in a job covered by Social Security, you pay a total tax of 7.65 percent to Social Security. Of this tax, 6.20 percent goes to the OASDI fund that pays retirement, survivor’s, and disability benefits, and 1.45 percent goes to the HI (Medicare) fund. However, not all of your earnings are subject to Social Security taxes; any income you earn over the maximum earnings limit (in 2016, $118,500) is exempt from the OASDI tax. This means that this year, the maximum OASDI tax you will pay (no matter what your income) is $7,347 (assuming a tax rate of 6.20 percent). The amount of HI tax you might pay is unlimited, because no portion of your income is excluded from this tax.
Tip: If you work for more than one employer during the year and earn more than the maximum earnings limit for the year, it’s possible that more than the maximum OASDI tax will be paid, because each employer is responsible for withholding the employee’s tax and paying the employer’s tax up to the maximum earnings base. If so, you’re entitled to a refund of your overpayment.
When you’re self-employed—If you’re self-employed, you pay a 15.3 percent self-employment tax on your self-employment income. Since 1990, 92.35 percent of all net earnings from self-employment has been taxable, unless the profession is not covered by the Social Security Act or unless the net income from self-employment is less than $400. Like wages from an employer, any income you earn over the maximum earnings limit is exempt, and no portion of your net earnings from self-employment is exempt from HI tax.
When you’re the employer—If you’re an employer who pays the wages of individuals covered by Social Security, you must contribute an amount equal to 6.20 percent of your employee’s salary to the OASDI fund (up to the maximum limit) and an amount equal to 1.45 percent of your employee’s salary to the HI fund.
Caution: You may also owe an additional Medicare payroll tax of 0.9% if your earnings (together with your spouse’s earnings if you file jointly) and/or net self-employment income exceed a certain threshold amount for your filing status. The threshold amounts are $250,000 if you file as married filing jointly, $200,000 if you file as single, head of household, or qualifying widow(er), and $125,000 if you file as married filing separately. The employer portion of the HI tax is not subject to the additional Medicare payroll tax. Employers are responsible for withholding the additional tax from employee wages in excess of $200,000 in a calendar year. If you’re employed and you owe more than the amount withheld, you’re responsible for making estimated tax payments or requesting additional withholding. For more information visit www.irs.gov.
Those Who Can Benefit from Minimizing Social Security payroll taxes
Business Owners
If you own a business, you may benefit from minimizing payroll taxes for two reasons:
1. Business owners must pay the employer share of the FICA tax (7.65 percent of the wages of each covered employee).
2. Business owners often have higher than average earnings (and thus may fall into the category of people who do not collect as much in benefits as they pay in Social Security taxes).
A Person Eligible to Receive Simultaneous Social Security Retirement Benefits
You may be eligible for both a worker’s retirement benefit based on your own earnings (a benefit equal to 100 percent of your primary insurance amount, PIA) and a spousal retirement benefit based on your spouse’s earnings (a benefit equal to 50 percent of his or her PIA). When you elect to receive retirement benefits, you must apply for both types of benefits at the same time. You will receive a combination of your own benefit and your spousal benefit that equals the higher of the two. Your own benefit is always paid first.
Example: Mary and Larry want to begin receiving retirement benefits. Mary is eligible to receive a worker’s retirement benefit based on 100 percent of her PIA. Her benefit will be $1,000. Larry is also eligible to receive a worker’s retirement benefit equal to 100 percent of his PIA. His benefit will be $450. However, Larry’s spousal benefit, based on Mary’s PIA (50 percent of her PIA, or $500), is more than the benefit he would receive based on his own PIA. So Larry will receive his own $450 benefit plus $50 of his spousal benefit. All the payroll taxes he’s paid over the years will not affect his own Social Security retirement benefit.
A Person who has Maximum Earnings in Each of the Earnings Years that will be Used to Calculate Their Social Security Retirement Benefit
Usually, your 35 years of highest earnings are used to calculate your Social Security retirement benefit. If you have worked at least 35 years and earned as much as the maximum earnings amount in each of those years, you won’t be able to increase your Social Security benefit by working longer. However, if you do work longer (and you may have to, if you’re not yet eligible to receive retirement benefits), you must still pay Social Security taxes on your earnings.
Example: Mattie began working when she was 20, and she has worked continuously since. She wants to retire and begin collecting Social Security retirement benefits when she reaches normal retirement age. She knows that she will receive the maximum individual benefit possible when she retires, because she earned the maximum base amount in 38 out of the 40 years she has worked. However, even though she will work and pay Social Security taxes during the next five years (until she reaches normal retirement age), her earnings won’t increase her retirement benefit.
Not Everyone Benefits from Minimizing Social Security Payroll Taxes
Not everyone should consider using a strategy to minimize Social Security payroll taxes. In particular, the following people will likely not benefit from minimizing payroll taxes:
Individuals who have low lifetime earnings
The Social Security benefit formula favors individuals with low lifetime earnings, and they’re more likely to receive a large Social Security retirement benefit in proportion to the amount they contributed to the system through payroll taxes. In addition, if they want to increase their benefit, they may need to earn more and pay more taxes in order to increase their average indexed monthly earnings (AIME) on which their benefit is based.
Workers Covered by Social Security whose Spouses are Not
If you’re covered by Social Security and elect to begin receiving benefits, your spouse may receive a spousal retirement benefit equal to 50 percent of your retirement benefit (at normal retirement age), even if he or she has never worked outside the home or in Social Security covered employment. This means that the return on your payroll taxes is increased by 50 percent. It’s likely that you will receive back in benefits what you have contributed through payroll taxes. In addition, even if you did attempt to minimize your payroll taxes, you may affect not only your benefit but your spouse’s benefit as well.
Strategies that May be Used to Minimize Payroll Taxes
The following table lists strategies that can be used to minimize payroll taxes and who might be able to use each strategy:
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Who Might Benefit from Using this Strategy
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Strategy
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Business Owner
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Person Eligible to Receive Simultaneous Benefits
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Person with 35 Years of Maximum Earnings
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Reduce Spousal Compensation
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Yes
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Yes
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No
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Bunch Earnings
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Yes
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No
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No
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Replace Compensation with Nontaxable Fringe Benefits
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Yes
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No
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Yes
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Reduce Earnings in Excess of the Maximum Earnings Base
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Yes
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No
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Yes
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Create Exempt Family Employment
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Yes
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Yes
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No
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Restructure Business Entity
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Yes
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No
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Yes
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Strengths
The money saved in payroll taxes can be invested elsewhere—If you save money in payroll taxes, you can take that money and invest it in another retirement plan.
Tradeoffs
When You Minimize the Amount of Social Security Taxes that You Pay, You May also Limit the Benefit You Receive
Minimizing your Social Security taxes may limit your Social Security benefits or the benefits paid to your family members. For example, when you own a business and limit compensation paid to a spouse, he or she may not be eligible to receive Social Security disability benefits in the future. In addition, if you and your spouse divorce before 10 years of marriage, your spouse won’t be eligible for any benefits based on your earnings record. Any strategy you use to minimize Social Security payroll taxes should take into account your whole financial picture. Because this is complicated, you may want to consult a financial professional before undertaking the strategy.
Business Planning Strategies May Raise the Ire of the SSA or the IRS
The SSA and the IRS may closely scrutinize any questionable business reorganization. For example, if you decide you want to create exempt family employment, you must ensure that the family members you pay are doing real work for you and that you’re paying them a reasonable wage. Otherwise, the SSA or the IRS may disallow your business arrangement.
Tax Considerations
Self-Employment Tax is Deductible
When you file your federal income tax return, you can deduct one-half of the self-employment tax you paid that tax year. (Note, though, that you won’t be able to deduct any portion of the additional Medicare payroll tax if you’re subject to it.)
Strategies to Minimize Social Security Payroll Taxes may Affect Your Income Taxes
Certain strategies you use to minimize your payroll taxes (such as restructuring a business entity) may also affect your income taxes. You should consult a tax professional or financial advisor before undertaking any tax strategy.
If you need help, contact the experts at Henssler Financial:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
Disclosures: The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
