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?