Social Security can be a tricky subject for many clients, with added complexity for small business owners. One common question concerns compensation for family members and their eligibility for Social Security. Here are the factors to consider.
A common question asked by business owners is whether or not they should put a spouse on the payroll to make them eligible for their own Social Security benefits. The wives of working husbands already qualify for spousal benefits, but these benefits are only 50% of the working husband’s primary insurance amount. Is it worth it to pay Social Security taxes on her so she can qualify for her own benefit?
There are a few ways salary can be arranged: the business owner might add the wife to the payroll and pay her a minimal salary to give her basic Social Security eligibility on her own work record. Or he might pay them both a high salary in order to maximize both spouses’ respective Social Security benefits. Or, once he’s qualified for a fairly high benefit, he might swap out his own high salary and pay himself little or nothing while paying his wife enough to give her more than the minimal Social Security benefit. There is also the question of how much business owners should pay themselves in salary to begin with, regardless of how it’s divided up between husband and wife. At its core, the question is about the return on investment a business owner might receive in exchange for paying self-employment taxes.
These self-employment (SE) taxes are not inconsequential. Business owners pay both the employee’s and the employer’s share of Social Security and Medicare taxes. Social Security taxes are 12.4% on salary up to $137,700 in 2020. Medicare taxes are 2.9% on all salary, with an additional 0.9% on salary over $250,000 for married couples.It definitely pays to minimize Medicare taxes because benefits do not increase with the payment of higher taxes.
Once you’ve paid a minimal amount into Medicare for 10 years, both you and your spouse qualify for free Part A starting at age 65. (Everyone over 65 qualifies Part B as long as they pay the monthly premiums.)
Adding your spouse to the payroll
Social Security is a different story. Social Security’s progressive formula means that the more you earn, the higher your benefit will be. But will your benefit be enough higher to justify paying the higher SE taxes? Let’s do some calculations using the Social Security Administration’s Detailed Calculator on the Social Security website.
Our hypothetical couple, Jerry and Jamie, are both 55 years old. Jerry has paid himself the maximum Social Security wage base since he was 30. Jamie has drawn no salary at all.
If Jerry continues to pay himself the Social Security wage base until he is 66, his primary insurance amount (PIA), or the benefit he will receive if he files for it at full retirement age, will be $2,824 in today’s dollars, according to the SSA Detailed Calculator. If Jamie reaches full retirement age (FRA) with no earnings record of her own, she will be entitled to a spousal benefit of 50% of Jerry’s PIA, or $1,412. Their combined benefit at full retirement age will be $4,236.
If Jerry continues to pay himself the maximum wage base and adds Jamie to the payroll at $20,000 a year for the next ten years, Jamie’s PIA on her own work record will be just $428, which is well below the spousal benefit. This would cost them more than $30,000 in selfemployment taxes on Jamie’s salary with no bump in Social Security benefits. It may not be worth it.
If Jamie goes onto the payroll at maximum salary, she could build her PIA up to $1,399. If Jerry is also receiving maximum salary, they would have a combined monthly benefit of $4,223 ($2,824 + $1,399). This is slightly less than what they would receive if Jamie just received a spousal benefit without taking any salary: $4,223 vs. $4,236. Yet they would have paid about $170,000 in additional self-employment taxes on her salary.
What if Jerry stops paying himself while paying Jamie the maximum Social Security wage base for the next 10 years? This will cost them no additional SE taxes because they are just assigning Jerry’s salary to her. Now Jamie’s PIA will be the $1,399, but Jerry’s PIA will drop to $2,443, for a total benefit of $3,842.
Compared to the status quo, where Jerry receives maximum salary while Jamie receives no salary, assigning the salary to Jamie would net them a lower monthly benefit: $3,842 vs. $4,236. It would also reduce Jamie’s survivor benefit if Jerry dies first: $2,443 vs. $2,824 (or $3,016 vs. $3,502 if he delays to age 70).
So the clear conclusion in this hypothetical case is that it would not be worth it for Jamie to start drawing a salary. If they pay her a minimal salary, they would pay additional SE taxes for a benefit she can’t use. Even if they pay her a high salary, it would give her a benefit that’s just about on par with the spousal benefit and costs them an additional $170,000 in SE taxes. If they stop paying Jerry and assign his salary to her, there would be no additional SE taxes, but it would lower their combined monthly benefit and significantly reduce her survivor benefit.
Effect of self-employment taxes
This example can also shed some light on the question of whether Jerry’s self-employment taxes on his own salary will pay off in higher Social Security benefits. At age 55, he already has 25 years of maximum earnings. If he has no further earnings, he will receive $2,443 at his full retirement age. If he works another 10 years at maximum salary, he’ll receive $2,824 at FRA, an additional $381 per month. This will cost him $170,000 in self-employment taxes.
How long will it take to make up that $170,000 in taxes? A long time. By dividing $170,000 by $381, we see that it will take 446 months, or 37 years, to break even. This means Jerry (or Jamie, as his surviving spouse) would have to live to age 103 in order for that last ten years of selfemployment taxes to pay off in higher lifetime benefits.
The conclusion here is that the payment of selfemployment taxes for a spouse over a 10-year period of time does not result in a Social Security benefit that is enough higher than the spousal benefit to justify paying the SE taxes. It’s essentially money down the drain.
As for the main business owner, the payment of SE taxes provides diminishing returns over time. That’s because the last tier of earnings is multiplied by only 15% in the PIA formula.
In Jerry’s case that last ten years of salary cost him $170,000 in SE taxes and netted him only $381 in additional monthly benefits. Perhaps that $170,000 could be better invested elsewhere. This is not to say that Social Security is a bad deal from the get-go. It’s only at the high salary levels that we see diminishing returns. It would be good to determine that point of diminishing returns where it makes sense for the business owner to stop paying himself a salary after he has already qualified for a relatively high Social Security benefit. However, this really requires customized inputs for the client’s individual situation.