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How to Help Small-Business Owner Clients Make Informed Social Security Decisions

For self-employed workers and small-business owners (SBOs), minimizing taxes is a top priority. They write off everything that can be and seek to minimize their reported incomes.

Retirement-minded SBOs, however, face another, often conflicting conundrum: whether to minimize tax liability now or maximize Social Security benefits later. Retirement benefits are based on beneficiaries’ earnings histories, so the more they minimize their reported incomes, the less they’ll be eligible to receive in retirement.

While SBOs nearing retirement can’t impact their earnings histories too much, clients in their 30s, 40s and 50s can. When working with self-employed clients, then, keep the following points in mind as you advise on Social Security and retirement income strategies.

Social Security nuts and bolts

The filing procedure is the same whether a retiree was employed, self-employed or owned a small business. And benefits are calculated the same way. Yet plenty of people don’t understand the basics of how the system works.

“It’s not the 10 highest earning years that count, it’s the best 35 years, indexed for inflation,” says Joy Kenefick, Wells Fargo Advisors managing director of investments. When SBOs and self-employed workers file their quarterly taxes, they’re reporting the income that’s subject to Social Security tax – and that counts toward their personal earnings histories.

What often confuses clients is that 10 years (i.e., 40 quarters) of reported earnings is the minimum amount necessary to receive any benefit at all. A short earnings history is still averaged over 35 years, and clients who only spent portions of their careers paying into the system will receive significantly reduced benefits.

Higher benefits later or lower taxes now?

Social Security is straightforward for sole proprietors and single-member LLCs. Their business and personal incomes are one and the same, reported on Schedule C of their 1040s. They pay personal income tax and both sides of the Social Security tax on the full amount, minus deductions -- and all of that income counts towards their earnings histories.

Matters are more complicated for clients with S-corps, who have more opportunities to earn big while avoiding taxes.

“A client who pays himself $50,000 to manage his company might pay himself another $150,000 in profit,” says Jennifer Myers, CFP with SageVest Wealth Management. “He’s making $200,000, less taxes, but he’s leaving $150,000 on the sidelines away from Social Security and Medicare taxes.”

But those profits are only exempt from the self-employment tax, and various personal and corporate income tax rates still apply. The current self-employment tax rate is 15.3 percent – 12.4 for Social Security and 2.9 for Medicare – so the example client above would save $22,950 compared with earning a $200,000 salary.

Making up the difference

Every benefit comes with a tradeoff, of course, and clients who opt for tax savings may see significantly reduced Social Security benefits. As of 2017, the payroll earnings cap is $127,000; someone who earned the maximum taxable earnings throughout his or her career will receive $2,687 per month at full retirement age. A consistent history of $50,000 per year, adjusted for inflation, on the other hand, would result in a monthly benefit of $1,847 – a difference of over a $10,000 per year.

That difference has to be made up somewhere.

“People think they’re being smart by minimizing their taxes, but if you’re not saving, you’re not being smart,” says Meyers. “If you want to self-fund your retirement, you need to be diligent in setting aside adequate savings and perhaps purchasing disability insurance.”

How much should SBOs set aside?

“If someone is not paying into Social Security, they probably need to save, at a minimum, 20 percent of what they’re earning,” says Meyers.

To determine a reasonable dollar amount, a high-earning couple might also consider the maximum Social Security benefit for which they would have been eligible, multiplied by 20 to 25 years.

“A $40,000 income that could have been received from Social Security is reflective of about $1 million in savings,” says Kenefick.

Clients: Can they save?

Still, needing to save and actually saving are two different matters. Because 401(k) and IRA contributions can be made only with personal earnings, minimizing taxable income minimizes the pool of money available for savings by its very nature.

For affluent SBOs who can count on significant S-corp profits, that’s not much of a concern. Using the same example client, $18,000 of her $50,000 salary might be placed into a 401(k). That’s not much of a cost to bear when she is still bringing in $150,000 in profits – and her salary ends up in a lower tax bracket, to boot. A profit-sharing plan, in fact, would allow her to contribute even more of her profits to her 401(k).

But “if you’re on the margins, it becomes more critical to take advantage of the bird in the hand – the Social Security income you know you’ll have in the future,” says Kenefick. Clients may like the idea of reducing taxes in the near term, but if they can’t stash away significant portions of their earnings, they’re not doing themselves any favors by compromising their earnings records.

Family matters

Single-income SBOs should take note: Minimizing earnings records will also reduce the amounts their spouses can collect. Spouses get up to half of their breadwinners’ benefits, but relative to their standards of living, they won’t be getting much if their families have lived primarily on profits.

If the business owner dies without having adequately saved, their survivor could be even worse off. They’ll be entitled to their spouse’s full benefit, but without substantial savings, that meager amount will have to cover property taxes, maintenance and other costs related to the amenities purchased with much more substantial profits.

Should SBOs with spouses and kids automatically opt for Social Security over tax savings? Not necessarily. With a stay-at-home spouse and children, however, it becomes even more important to replace that income stream.

An honest look

Minimizing Social Security and saving more for retirement can be a solid strategy for high-earning SBOs who consistently save.

“I typically lean towards taking advantage of the tax savings because we don’t know what’s going to happen with the tax code in the future,” says Kenefick. “Capitalizing on what you know you have is my MO.”

For lower earners and inconsistent savers, however, it’s a risky proposition.

“Your clients have to be honest with themselves,” Kenefick adds. “If you recognize you’re not a good saver, that should be the impetus for paying yourself more.”

Taking a higher salary will allow a client to collect more Social Security in the future and contribute more to their retirement accounts – both of which will be critical for clients who haven’t saved enough or contributed enough to Social Security thus far.

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