One of the benefits of forming an S Corp is that it lets you take a portion of your business income as a distribution rather than through a paycheck, avoiding payroll taxes. However, payroll taxes are the primary way the United States funds Social Security, so it’s understandable to wonder how forming an S Corp could impact your retirement benefits.
If you’re considering electing to be an S Corp with the Internal Revenue Service (IRS) for tax purposes, here’s what you can expect regarding Social Security.
S Corps and payroll taxes
One key benefit of an S Corp business entity is that it helps shareholders mitigate some of the costs they incur due to self-employment tax. When you’re self-employed, the money you earn is treated as wages. Wages are subject to payroll taxes.
Typically, when you’re an employee, your employer pays half of your payroll taxes, and you, the employee, pay the other half. When you’re self-employed, you’re both the employer and employee, which means you pay taxes for both halves.
The payroll tax rate totals 15.3% on your first $160,200 of income in 2023. Of this amount, 12.4% is for Social Security and 2.9% for Medicare taxes. After your first $160,200, you will not be subject to Social Security but will still have to pay 2.9% for Medicare taxes.
If you form an S Corp, you typically pay yourself reasonable compensation, which is subject to FICA taxes, including Social Security and Medicare taxes. You can also take distributions from your company’s profits.
Distributions are business profit and are not considered self employment income. That means distributions are not subject to payroll taxes, so you save 15.3%. You’ll still pay regular federal income tax on the distribution portion. It’s important to note that avoiding the Social Security tax by taking advantage of distributions does reduce your future benefits. However, as we will discuss later, the reduction in benefits could be worth it.
The employer side of your self-employment taxes is also an allowable business expense, further reducing your federal income tax liability.
How Social Security benefits are calculated
Your Social Security benefit depends on a few factors, including the age at which you retire and when you choose to start taking your benefit. It also depends on how much money a retiree earns throughout their career.
Eligibility for Social Security benefits is contingent on accumulating at least 40 credits during your working career. You can earn a maximum of four credits per year, and credits are earned by making a nominal amount in wages. For 2023, you’ll earn one credit per $1,640 earned, meaning you must earn $6,560 overall to earn the maximum of four credits for the year.
Assuming you’re eligible for Social Security, your benefit is determined not by how much you earned in your last year of working but by the wages you received in the 35 years where you earned the most money. Each dollar you earn, up to the Social Security wage base, gets added to your lifetime earned income.
The Social Security Administration then finds your average monthly earnings during your 35 most lucrative years, with an adjustment for changes in national wage levels. This is your Average Indexed Monthly Earnings (AIME).
Your benefit, called your Primary Insurance Amount (PIA), is determined using a mathematical formula. This formula includes two income milestones called bend points. Income up to the first bend point ($1,115 in 2023) has a bigger impact on benefits than income between that first milestone and the second one ($6,721 in 2023). Income in excess of the second bend point has a negligible impact on benefits.
In short, as your earnings increase, the speed at which your benefit rises decreases.
The formula for calculating your PIA is:
90% of your AIME up to the first bend point + 32% of your AIME up to the second bend point + 15% of your AIME for income after the second bend point
Your PIA is then adjusted for factors like the age when you start taking the benefit.
How S Corps impact Social Security benefits
One key thing to note with these calculations regarding your benefit is that not all earnings count toward Social Security.
The Social Security Administration looks only at wages earned, not your overall income. Money you make working for an employer or that you pay yourself as a reasonable salary are wages and count toward your benefits. Things like investment income or distributions from your S Corp do not.
This means that the S Corp tax structure will reduce your Social Security benefit somewhat. Taking some of your company’s profits as distributions rather than wages means mitigating the payroll tax but also keeps that income from counting toward Social Security.
The good news is that most people will find the decrease in benefits to be negligible compared to the tax benefits of forming an S Corp.
For example, let’s say that Jane has a consulting business. It’s incredibly consistent, earning exactly $100,000 in profit in 2023. Her profits increase by precisely the rate of change in the national wage index each year. She works for 35 years before deciding to retire.
That leaves her with $3.5 million in earnings (in today’s money) that were subject to the Social Security tax. Her AIME, which consists of her average monthly earnings during her 35 most lucrative years, is $8,333.33.
Using the formula above, we can calculate that her PIA (or monthly benefit) will be:
(.9 x $1,115) + (.32 x ($6,721 – $1,115)) + (.15 x ( $8,333.33 – $6,721)) = $3,039.27
Assuming Jane takes Social Security benefits at full retirement age (FRA), she’ll get the full benefit of $3,039.27 per month in Social Security income.
Now, imagine she chose to form an S Corp at the beginning of her career. She pays herself a reasonable compensation of $60,000 per year, taking the remaining $40,000 in profit as a distribution.
Her new AIME is $5,000, resulting in a PIA of:
(.9 x $1,115) + (.32 x ($5,000 – $1,115) = $2,246.70
Jane’s monthly benefit is $792.57 smaller. However, she lowered her payroll tax liability by 15.3% on $40,000 of income each year for 35 years, which is a total savings of $214,200. It would take a little more than 22 years of the higher Social Security benefit to receive more than she would save through her S Corp.
Given how bend points work when calculating Social Security benefits, the benefit of an S Corp is even more pronounced for higher earners because the reduction in benefit will be smaller.
What S Corp owners can do to prepare for retirement
If you decide to form an S Corp, there’s a possibility that it will impact your future Social Security benefits. Distributions aren’t subject to Social Security tax. However, they don’t count toward your future benefit, lowering how much you’ll receive in retirement.
So, what can you do about this?
The first option is simply not to worry. The greatest benefit of Social Security comes from income up to the first bend point, which is set at $1,115 in monthly wages for 2023. The returns diminish significantly after that.
The amount you can save in taxes by forming an S Corp is large compared to the reduction in your future benefits. Considering that a dollar today is worth more than one tomorrow (or in 35 or 40 years), you’re likely better off taking advantage despite the reduction in future benefits.
If you’re still worried about your retirement plan, a great thing to do is to put some of the money you saved on payroll taxes into a retirement account. A Solo 401(k), SEP IRA, or insurance contract like an annuity allows you to build a nest egg for retirement. It could easily provide an income stream similar to or greater than Social Security.
Forming an S Corp and taking some of your earnings as a distribution rather than wages will reduce your taxable income and future Social Security benefits, but you do not need to worry. The impact of lower tax payments will be relatively small compared to your tax savings. Plus, you can easily offset the lower benefit with increased retirement savings funded through the tax savings that distributions provide small business owners.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or financial advice. You should consult your own legal and financial advisors to determine the the legal setup of your business.
TJ Porter is a freelance writer based in Boston, Massachusetts. He began covering finance while earning a degree in business at Northeastern University in Boston, Massachusetts and enjoys writing about credit, investing, real estate topics. When he’s not writing, TJ enjoys cooking, sports, and games of the video and board varieties. You can contact him at find more of his work at TJPorterWriting.com