Higher 401k contrib/payroll taxes or lower 401k contrib/lower payroll taxes?

[Carlotta]

Long-time lurker here. (HI!)

I'm wondering if you smartypants can give some advice on making employer contributions to 401ks v. paying payroll taxes.

My husband and I own and do work through an S-corp. (I also have a full-time job with a separate employer.) I would like us to max out our 401k contributions for the year: $17,500 for me, $23,000 for him (>50). All good there.

Where I'm getting stuck, though, is setting our reasonable compensation to balance the ability to put away more money tax-deferred via an employer contribution (20%) v. paying less in payroll taxes on said reasonable compensation for the year.

We're not talking about huge amounts here: the business before expenses will probably make $65,000 by year's end. So the range of reasonable compensation for each of us is within about $5000 either way -- and therefore well within the "reasonable" part of "reasonable compensation" regardless.

But I would really like to maximize any advantages we may have (i.e., keep as much in our pockets as possible). I just can't seem to figure which is the better way to go:

a. pay each of us the higher-end salary, thereby increasing the amount of the employer contribution to be tax-deferred, but also raising the payroll tax hit, or

b. pay each of us the lower-end salary, thereby decreasing the amount of the employer contribution to be tax-deferred, but also lowering the payroll tax hit.

This gentlemen -- http://evergreensmallbusiness.com/pension-deductions-versus-payroll-taxes/ -- suggests the higher payroll hit just isn't worth it, but I'm not sure I agree w/ his numbers. I also admittedly got lost in his calculations about 3/4 through. I'd love to hear some Mustachians' opinions/experiences. For reference, we skirt back and forth over the 15%/25% fed tax bracket line, but post-retirement, we'll definitely be in the 15% end of the pool.

Thanks very much for your thoughts.

[Kira]

I read it and I think I got about 90% of the math there.. :)

He says that contributing more to the retirement account wins, but it only wins in a long-term scenario where you are investing at a steady 6% for 20 years. If your husband is over 50, you may not be looking at that long of a timespan before you want to get to your money.

More importantly, it also depends on how much other income you have this year. He is using a 2.9% medicare tax rate - which only applies if your other income is significant, and the money from the S-corp would be taxed at the above-maximum-income rate.

From SSA website: http://ssa-custhelp.ssa.gov/app/answers/detail/a_id/240/~/social-security-and-medicare-tax-rates%3B-maximum-taxable-earnings

Also, beginning in 2013 you must pay 0.9 percent more in Medicare taxes on earned individual income of more than $200,000 ($250,000 for married couples filing jointly). The tax rates shown below do not include the 0.9 percent:

Employees — the Social Security tax rate is 6.2 percent on income under $113,700 through the end of 2013. The Medicare tax rate is 1.45 percent of all income;
Employers — the Social Security tax rate is 6.2 percent. The Medicare tax rate is 1.45 percent; and
Self-employed —the Social Security tax rate is 12.4 percent on income under $113,700 through the end of 2013. The Medicare tax rate is 2.9 percent.

So that's where he's getting 2.9% plus income tax rate. It gets a little more complicated for you because you are both self-employed and an employee. But the worst case scenario, if your other income is below $113,700, you will pay 15.3% on the income below that line PLUS regular income tax. And then you are DEFINITELY not going to come out ahead if you make yourself pay more in income tax in order to get a bigger retirement fund contribution.

[Numbers Man]

This is a very complicated question. "What If" scenarios should be run through with your accountant who has tax software. There are so many rules on what can be deducted depending on what your retirement vehicle is (such as 401k vs SEP IRA) and if you have employees. This also includes on what profit sharing can be contributed as well. You will probably have to consult with the financial institution that is holding your retirement plan assets AND your accountant to optimize what you want to do and to find out all the benefits and costs.

[SeattleCPA]

I saw this post about a post on my blog and thought I'd sign up to answer your questions...

So here's the deal. Say you have $50,000 of business profit. While it would seem like a no brainer to throw that money into a retirement account, it's not always so clear when you have a small business corporation  (which is what the original post was about)...

For example, while you might be able to (say) bump your salary by $50,000 and then as a result be able to make a larger contribution to your retirement account, bumping your salary by $50,000 could bump your FICA taxes or Medicare taxes by 2.9%, 3.8% or 15.3%... so you probably want to consider that. Obviously, if you pay a roughly 15% tax on the extra $50,000 of income, that's a lot.

Also, you want to consider that the "savings" associated with a retirement account is really only a deferral.. you do have to pay the taxes back later on.

So things get tricky. E.g., would you really make money by paying an extra $7500 in payroll taxes so you could delay paying (say) $15,000 in income taxes for ten or twenty years... The math, as you note, gets really complicated. But often this tradeoff doesn't work.

If you're paying a 2.9% or 3.8% tax, things are a little murkier... but I would suggest you want to (a) recognize that any payroll taxes you pay to "get" earnings need to be included in your analysis and (b)  that you want to remember the deferred taxes need to paid back at some point.