Kitces: Wrong Way to Cut Client Taxes

No one likes to pay any more in taxes than they have to, so it’s not surprising that advisors use the many strategies legally available to try to reduce the tax burden of clients.

However, in the case of FICA taxes, strategies that reduce earned income to avoid them also reduce the income used to calculate an individual’s Average Indexed Monthly Earnings (often referred to as AIME) — which in turn is used to determine future Social Security benefits.

As a result, strategies that seek to minimize your clients’ payroll and/or self-employment taxes can also, ultimately, reduce their Social Security income. And while the forgone benefits may be quite modest for higher-income individuals, the adverse impact can be quite substantial for those with limited lifetime earnings.

To calculate an individual’s Primary Insurance Amount (or PIA) — the retirement benefit the individual would be eligible for at full retirement age, before being reduced or increased for starting early or delaying — the Social Security Administration first reviews the individual’s entire earnings history. It then inflation-adjusts those historical earnings up to a current-dollar wage equivalent based on the national wage index.

Once the earnings history has been adjusted, the agency adds together the inflation-indexed earnings from the highest (not necessarily consecutive) 35 years and divides them by 420 — because 12 months x 35 years = 420 months. This process produces the AIME over the person’s lifetime.

REPLACEMENT FACTOR

The Social Security Administration then needs to convert that figure into the individual’s actual PIA, so it applies which it calls a replacement factor. As a retirement benefit, the individual’s PIA is 90% of the first $826 per month of AIME, 32% of the next $4,154 per month (up to a total of $4,980 per month of earnings), and 15% of the remainder, up to the maximum (the Social Security wage base).

These “bend points” — the crossover points where the replacement rate is decreased from 90% to 32% to 15% as income rises — are themselves annually indexed for inflation. (See the “Tax Obligations as Income Rise” chart below.)

Ultimately, the formula for calculating Social Security benefits is little more than an income replacement formula, similar to the pension payable under a defined benefit plan (which also provides a percentage of wages earned as a retirement benefit).

Yet an important caveat is that only certain types of income are included in the formula in the first place. Specifically, in order for income to be counted toward Social Security benefits, it must be earned income — for example, generated from wages or self-employment — and it must be taxed as earned income, which means it’s subject to FICA taxes.

TWO TAXES

Technically, FICA (the tax paid under the Federal Insurance Contributions Act) is made up of two different taxes — a 12.4% tax for Social Security benefits and a 2.9% tax for Medicare. Self-employed individuals pay the entire 15.3% total themselves; for employees, half is paid by them and the other half is paid by employers on their behalf, in the form of payroll taxes.

The Social Security portion of the tax, though, only applies to earned income up to the Social Security wage base ($118,500 in 2015), while the Medicare tax applies to any and all earned income, with no limit.
Separately, a 0.9% Medicare surtax now also applies on earned income above $200,000 for individuals ($250,000 for married couples). This is illustrated in the “5 Steps to Calculating Benefits” chart below.

In this context, the Social Security wage base serves a dual role: It’s the cap on the maximum income to which the Social Security portion of FICA taxes will apply, and it’s also the maximum amount of income that will be used to determine AIME when calculating benefits.

Again, the earned income actually must have FICA taxes paid on it in order to be counted as income to determine Social Security benefits.

For that reason, tax-minimization strategies that seek to avoid FICA can also reduce Social Security benefits, because income that isn’t taxed for FICA purposes isn’t counting for AIME, either.
For instance, take one popular strategy: converting a business to an S corporation so that owners can be paid a more modest salary (subject to FICA taxes) and take out the rest as dividends (not subject to FICA taxes). The trouble is that doing so can reduce Social Security benefits if wages are brought so low they’re under the base.

Similarly, shifting income from a lower-income spouse (below the wage base) to a higher-income spouse (above the wage base) could save the 12.4% Social Security share of FICA taxes for the lower-earning spouse — but, again, has the potential to lower future Social Security benefits.

And businesses — or employees — that operate on a cash basis to avoid reporting income at all for tax purposes can successfully (albeit illegally) exclude the income from FICA and other taxes, but also wind up excluding it from the formula determining Social Security benefits.

THE IMPACT

So how much can avoiding FICA taxes actually impair a client’s Social Security benefits? The impact depends heavily on the existing earnings already on the client’s record.

Because AIME is calculated as a 35-year average, each year of higher income adds 2.86% (essentially 1/35th) of its value to AIME. For instance, a client who earned $60,000 a year (or $5,000 per month) would increase AIME by $142.86 (if she didn’t already have 35 years of earnings).

If she had lifetime earnings below the first bend point, 90% of this would be received back in benefits — in other words, paying 12.4% on the $60,000 of income would increase her lifetime payment by $128.58 a month, starting in retirement.

Viewed another way, trying to save a $7,440 tax payment would come at a cost of losing $1,542.96 per year — for life — in Social Security payments.

On the other hand, if the individual already had enough income for AIME to fall past the first bend point — that is, when the replacement rate would only be 32% — the Social Security benefit would be diminished; that same $7,440 tax payment would have only produced an increase of $45.71 per month, or about $548.57 per year.

And if income was already high enough to reach the upper bend point, that tax payment would only be producing benefits of $21.43 per month, or about $257.14 per year in retirement.

INCOME FACTOR

Given this dynamic, the reality is that the higher an individual’s income already is, the less harm there is — in the form of forgone Social Security benefits — by trying to avoid FICA taxes, assuming the FICA avoidance tactic is legal.

For an individual who already has at least 35 years of earnings, for instance, the benefit of FICA taxes could even be zero if the new year of earnings is below the prior 35 years of (inflation-adjusted) earnings. In such a case, the FICA tax savings would have no adverse impact on Social Security benefits.

However, at lower benefit levels, the potential return on paying FICA taxes can be quite significant. That’s especially true for those already close to retirement. In that case, because the taxes would get paid now and the benefits would begin soon, any forgone growth on the taxes would also be minimal.

Additionally, for those who may not even have their required 40 quarters of credits to get Social Security benefits, adding in a few more years of FICA taxes can produce a dramatic return by rendering that year’s FICA taxes — and those from all prior years — eligible for benefits in the first place.

This also means that, in some situations, it may even pay to shift earned income to an individual in an attempt to pay more in FICA taxes. That’s especially true if it can push that person over the 40-credit threshold, or if that person’s AIME is still low enough to increase benefits at the 90% replacement rate. (Or both, for that matter.)

The bottom line: FICA taxes are unique in that the income on which they are paid is directly linked to the income used to calculate future Social Security benefits.

As a result, it’s important to be cautious in efforts taken to help your clients avoid FICA taxes — because in the long run, this can actually produce less long-term wealth by forgoing potentially significant Social Security benefits.

Michael Kitces, CFP, a Financial Planning contributing writer, is a partner and director of research at Pinnacle Advisory Group in Columbia, Md., and publisher of the planning industry blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.

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