Social Security for Business Owners
posted by Fisher 401(k) September 13, 2018
For most American workers, Social Security looks pretty much the same; Federal Insurance Contributions Act (FICA) taxes, which are made up of taxes for both Social Security and Medicare, come out of each paycheck—and when retirement comes, so do those benefits. There are some decisions to make about when to start taking Social Security benefits, but the process of paying in is fairly automatic. For business owners, however, it’s not quite that simple. Depending on how a business owner takes income from their business earnings, they may see drastically different benefits. There’s a lot to think about when it comes to how benefits are calculated, how Social Security taxes are paid, and what role Social Security will play in a business owner’s retirement strategy.
How Social Security Benefits are Calculated
The Social Security Administration (SSA) calculates an individual’s benefits by averaging their earnings across the 35 years in which they earned the most income. By indexing each year’s income against average wages for each of the 35 years and determining the average, the SSA determines a “primary insurance amount,” which is the amount an individual would receive monthly at full retirement age of 65 or later, depending on their year of birth.1
How FICA Taxes are paid
Social Security is paid for by taxes collected on workers’ income and by a trust fund dedicated to the program. When a normal employee gets paid, they pay 7.65% of their income to FICA, with 6.2% going to Social Security and 1.45% to Medicare.2 The employer then matches the FICA tax, so a total of 15.3% FICA tax is paid. For many business owners, however, income doesn’t go through payroll and therefore isn’t automatically subject to payroll taxes like FICA.
To account for this, business owners are required to pay something called the self-employment tax, which totals 15.3% of their earnings—the same amount as the total FICA taxes paid on regular payroll income. In effect, the business owner is paying both the employee and the employer FICA taxes on their income in this way.3
How Social Security Works for Different Business Structures
The owners of businesses have several different ways of taking income, depending on the corporate structure of the company. In most cases, business owners will end up paying self-employment tax on their share of profits, but some pay regular income taxes on portions of their income. Each method of income brings its own unique considerations for owners who are conscious of their Social Security benefits come retirement.4
Draw: Sole Proprietors, Single-Member LLCs
Sole proprietors and the owners of single-member LLCs are paid by taking a draw from the business’ profits. These business owners can take as much or as little income from the business as they’d like. That said, the business itself is a pass-through entity, meaning the business itself does not file or pay any taxes. Whether the owner takes all the profit in a year or only a portion, that profit is subject to both regular income taxes as well as the self-employment tax.
Sole proprietors and single-member LLC owners pay a hefty tax on their business’ profits, but there is an advantage when it comes to Social Security benefit calculation. Regardless of how much take-home income these business owners might see in a given year, the SSA will count ¬all¬ of their profit when calculating the owner’s Social Security benefits. So even in years when an owner chooses to invest significant profits back into the business rather than take those earnings as income, those high-profit years will help to raise the average of the owner’s 35 highest-earning years.
Distribution: Partnerships, Multi-Member LLCs
A distribution is similar to a draw, with the key difference being that a distribution is reported on the individual owner’s tax return using a Schedule K-1. Business owners in a partnership or multi-member LLC will take their income as a portion of the business’ profits, according to the division of profits identified in the business’s operating agreement. Each partner pays both income and self-employment tax on their distributions.
Much like sole proprietors, partners will benefit from a Social Security standpoint by paying FICA taxes on their entire portion of the business’ profits. Even if a partner only takes a portion of their distribution as actual income, the self-employment taxes paid on the entire distribution mean that the business’ most profitable years will all factor favorably into the individual partner’s 35-year average when it comes time to calculate Social Security benefits in retirement.
Individuals who own shares in a corporation but do not work in that corporation are paid dividends, which are portions of profits that the corporate board can decide to pay out to shareholders. This income is recorded by an individual owner as dividend income, but is not subject to self-employment tax and therefore does not pay into Social Security.
Because FICA taxes are not paid on dividend income, no dividend earnings will factor into the calculation of Social Security benefits. For business owners whose income is largely comprised of dividend earnings, there may be a more significant challenge in establishing 35 years of income to generate a significant Social Security benefit in retirement.
Salary: Corporations, LLCs That Elect to Be Taxed as Corporations
If they work for their corporation in addition to owning it, a business owner may take an actual salary, which is paid through payroll and has all income and FICA taxes taken out on each paycheck. The owners of some LLCs who work in their business may also elect to be taxed not as a pass-through entity, but as an S-Corporation. For those LLC owners, they’ll pay FICA taxes only on the portion of their income that’s paid out as a salary, and will then only pay income taxes (and not self-employment taxes) on the rest of the company’s profits.5
The IRS is serious about making sure that corporate shareholders who are also employees don’t avoid paying payroll taxes by underpaying their salaries in favor of increasing distributions of profit, which are not subject to self-employment taxes.6 With that in mind, owners who are able to take a salary are expected to pay themselves “reasonable compensation” for their work, just as they’d pay any other employee doing the same job. For the purposes of Social Security, that means any income paid as salary will pay into Social Security, setting these owners up for Social Security benefits in line with their salary. Keep in mind that any earnings beyond this salary do not pay into FICA, and therefore will not be counted when calculating your Social Security benefits.
Other Considerations for Retirement Planning: Adding a 401(k) Plan
While the way you earn your income as a business owner plays a significant role in shaping your benefits, there are some other contributing factors to consider when planning around Social Security. And, no Social Security payout will likely be enough to cover all your expenses in retirement. Social Security should be considered supplementary income, with other sources of savings like a 401(k) providing more of what you need to live a full and dignified retirement.
How a Company 401(k) Plan Benefits Business Owners
A company 401(k) can provide many benefits to entrepreneurs and business owners, both in terms of attracting and retaining key employees, and also by giving employers many options for saving pre-tax dollars in their own accounts that can be invested and grown over time. SEP IRAs and SIMPLE IRAs can work well for businesses with fewer than 10 employees, as they offer employees and owners the ability to save and are relatively easy to set up and manage.7 For larger companies, traditional 401(k) plans can take on many different forms to match with your goals as a business owner. Profit sharing plans, for example, can help you control your contributions while potentially allowing far higher contributions to your own account.8
As you consider your retirement, think through how your current business structure impacts your Social Security benefit. Some business owners may be paying into Social Security with each dollar of profit their company earns, while others may enjoy significant dividend income without paying FICA taxes whatsoever. The key to successful retirement planning is understanding the variables at play and making smart long-term decisions today—like starting a 401(k) for your business—to ensure you’ll have the funds you need to support you when your working years are done.