Author Topic: SoloK Case Study - Two High W2 Incomes + High Business Income  (Read 4978 times)

mr_orange

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SoloK Case Study - Two High W2 Incomes + High Business Income
« on: November 04, 2015, 09:31:12 PM »
Scenario:
-W2 Salary Me - $110k or so
-W2 Salary Wife - $100k or so
-"Side" Business Income Via S-Corp - Unknown, but assume $600k or so
-Tax Year 2015
-Desire to reduce taxes, but ultimate goal is maximal after-tax income over next X years
-Non-Tax-Deferred dollars can be invested in active projects and get higher yields than investing passively
-Tax-Deferred dollars will be invested passively in index funds and will get lower yields than the non-tax-deferred dollars

So I spoke with an expert CPA from Ohio today that specializes in this type of stuff. I have yet to speak with my CPA yet, but I did email him this evening. This is my understanding of what is happening:

-The employee contributions to social security DO cap out. I looked the limits up for 2015 and it appears to be $118.5k
-The employer contribution to social security DOES NOT cap out apparently. This is a big deal and not something I understood until today's call
-The medicare taxes don't cap out. Those are still 2.9%
-The 25% cap on distributions to the SoloK applies

So the math works out like this;

Wife's W2 income == $100k or so
My W2 income == $110k or so

That leaves about $18.5k + $8.5k == $27k that is subject to both sides (employer and employee....total of 12.4%) of the social security tax. Everything thereafter is subject to half of the social security tax (6.2%) and the medicare tax (2.9%); or 9.1%. So to make the math simple let's just round up and call it 10% because of the $27k subject to another 6.2%, or 12.4% total. The exact percentage will depend on what we call earned income in the example. Even at the lower bound of 9.1% the results below still have the same logic applied.

My federal tax rate was apparently roughly 30% last year. I need to get with my accountant and see where this figure is cited, but this is what the expert CPA told me today after reviewing my returns. This number has to be scaled by 25% though because I can only get the expense for the contribution for 1 of every 4 dollars. That is all that I'm allowed to divert to my SoloK. 25% of 30% is 7.5%. The top federal tax rate is 39.6% currently which would scale to roughly 10% by only using 1 of every 4 dollars. I don't known what my actual rate will be this year, but it is likely to be between 30% and 39.6%, which means I'd get roughly 7.5% to 10% savings in federal taxes by diverting funds from my S-Corp to the SoloK by declaring them as earned income.

So....the next questions are:

1. Do the math and rules above look correct?
2. Is it worth possibly paying as much as (could be 0% at higher tax rates) 9.1% - 7.5% == 1.6% in extra taxes in 2015 to be able to defer taxes on the money contributed to the SoloK for X years? I'm assuming X would be in excess of 10 or so at a minimum given my age and goals. I'd be trading off control of the money in all types of projects for favorable tax treatment and declaring this money as strictly passive investing money

Any thoughts?
« Last Edit: November 04, 2015, 10:11:23 PM by mr_orange »

MDM

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #1 on: November 04, 2015, 09:46:27 PM »
-The employer contribution to social security DOES NOT cap out apparently. This is a big deal and not something I understood until today's call
You might ask the CPA for an IRS document reference on that one, as it conflicts with general understanding.

https://www.irs.gov/publications/p15/ar02.html#en_US_2015_publink1000202402 would suggest there is a cap.

Non-IRS articles such as http://biztaxlaw.about.com/od/glossarys/g/socialsecmax.htm also suggest there is a cap.

mr_orange

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #2 on: November 04, 2015, 10:10:24 PM »
I hope you're right.  I think what may be happening is that the "employer match" for our business doesn't account for the employer match through my W2 employer.  Thus I may owe taxes on the first $118.5k in payroll through my S-Corp.  Since I only get 25 cents of every dollar here I'd need to make 4X this amount, or $474k in payroll, to max out the SoloK I think. 

Are there any tax wizards on here that know the answer to this?  It is all pretty confusing to me.  Things certainly would be a lot better if the W2 FICA contributions from my day job employer counted to offset the $118.5k cap for my S-Corp. 

mr_orange

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #3 on: November 04, 2015, 10:27:57 PM »
MDM....the linked article in the second article (this one: http://biztaxlaw.about.com/od/typesofbusinesstaxes/f/Self-Employment-Tax-And-Taxes-From-Employment.htm) you sent states this:

//Quote
Schedule SE - Calculating Self-employment Tax

To show you how employment and self-employed are considered for Social Security and Medicare taxes, here is the the (vastly over-simplified) process for calculating self-employment tax on Schedule SE:

First, the net income from your business for that year is entered.

Second, the amount of self-employment tax owed is calculated.

Third, any income from employment and the amount of FICA tax is considered.

Finally, the amount already paid from your employment is deducted from the total Social Security/Medicare tax owed. If there is anything left, it is paid as self-employment tax, on your personal tax return.
//End Quote

So that would seem to imply the accountant was wrong.  If this is the case we should only owe 12.4% in FICA on the difference between $118.5k * 2 and $210k (or $100k plus $110k), or $27k.  We'd then owe 2.9% on anything in excess of $118.5k that was used to declare it as earned income.  Thus our payroll tax rate would be closer to 3% and not 10%ish. 

So if this is the case we'd be trading roughly 3% in payroll taxes for between 30% * .25 and 39.6% * .25 (or 7.5% and 9.9%) in federal tax reduction.  That seems like a good trade to me provided it is correct.

Does this look correct?  You have to parse the language above to determine whether or not "the amount already paid from employment" includes the employer match.  It is not very clear whether it does or doesn't apply. 
« Last Edit: November 04, 2015, 10:43:02 PM by mr_orange »

MDM

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #4 on: November 04, 2015, 11:03:33 PM »
To show you how employment and self-employed are considered for Social Security and Medicare taxes, here is the the (vastly over-simplified) process for calculating self-employment tax on Schedule SE:

See https://www.irs.gov/pub/irs-pdf/f1040sse.pdf.  Lines 6 through 9 are the pertinent ones.  For an individual it seems straightforward enough: you do get to deduct W-2 wages from the $118,500 (or whatever the current year's limit) before you pay the 12.4% portion of the SE tax.

From an employer's perspective, it doesn't matter how much an employee made at another job.  The employer has to pay 6.2% on wages up to the wage limit.  This is explained well in http://money.stackexchange.com/questions/29091/how-does-the-social-security-wage-base-apply-to-employers (and the links to the pertinent US Code).

S-Corps are out of my ken so I'll not venture an opinion there.

mr_orange

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #5 on: November 04, 2015, 11:23:24 PM »
Thanks....this is quite helpful. 

I don't think the S-Corp matters in the discussion really, but if it does someone please step in and tell me I'm wrong.  The whole point of the S-Corp from my understanding is to be able to divide the salary and dividends during a distribution to limit FICA (or more accurately social security) taxes.  In my case I am trying to increase salary to get an offsetting federal tax deduction.  From what you have linked it seems like I'm going to have a net negative 1.6% to 0% tax bite in the current tax year for taking distributions as earned income to make them eligible for tax deferral into the SoloK. 

The next question if this is correct is how many years the taxes would have to be deferred to make up for the difference in the initial tax hit we'd have to take in year 0 to make it worth moving the money over.  Part of this analysis has to do with risk too given how our entities are set up.  It is undesirable to leave the money sitting in our S-Corp because it is our active deals entity and is thus subject to more risk than it would be if all of the money was distributed and deployed to other entities or to our personal tax return. 

Any thoughts on that?

Proud Foot

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #6 on: November 05, 2015, 08:38:27 AM »
The whole point of the S-Corp from my understanding is to be able to divide the salary and dividends during a distribution to limit FICA (or more accurately social security) taxes.

In essence this is true although the fact that you have a W-2 job along with the S-corp makes this more complicated.  Another thing to remember with the S-corp is that if you are an employee/owner you need to pay yourself a "reasonable" salary for the position you are employed.

Since you are an owner of the S-corp and are privy to your wage information from your W-2 job you might talk with your CPA about whether you can use paystubs from your W-2 job to document when you have hit the SS max combined from the S-corp and W-2 and cease SS withholding and employer contributions from the S-corp.  I have no idea if this is legal and am not about to recommend that you do this, but it seems like it would be worth looking into.

Vilgan

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #7 on: November 05, 2015, 09:55:06 AM »
1) Employer part of FICA caps out for LLC taxed as partnership/sole prop, but (to my understanding) as an s-corp its no longer "self employment tax" its more like a regular company with taxes like unemployment tax, FICA, etc. It has to pay your portion of FICA up to the limit irregardless of what your regular w-2 employer has done. You might be able to find a CPA that knows how to avoid paying this.

2) You are correct about Medicare not capping out, but its not just 2.9% at your income level. There's an additional 0.9% applied once your joint income exceeds 250k. See https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare-Tax . This is (to my understanding) the sum of your w-2 from both sources and your wife's w-2 income from both sources.

3) You can use the mega backdoor roth trick to shelter up to the 53k limit if you don't hit it already with employee deferral + profit sharing. See https://thefinancebuff.com/after-tax-contributions-in-solo-401k.html . This is after-tax, so great from a tax sheltering perspective but less exciting from a reducing taxes now perspective.

4) You have an overall 53k limit on employee deferrals + employer matching + profit sharing. You should already be able to defer 18k with either income source before worrying about any 25% stuff so the amount you are thinking you need to have as w-2 income is way too high. Even if the taxes are worth it, you only need to shelter 106k - 36k - any employer matching. Assuming no matching, that's 70k, so 280k W-2 from your s-corp not 474k.

5) solo 401k investing does not need to be as passive. You can invest in real estate or a variety of other things with a solo 401k, but you'd need a self directed 401k rather than the free ones from Fidelity/Vanguard.

You'd essentially be paying an extra 10% FICA (3.8% medicare after 250k joint and 6.2% employer portion) just to defer taxes to be paid later. That is probably worth it if you are in the 39% bracket, as long as living on a lower income is part of your long term plan.
« Last Edit: November 05, 2015, 10:03:36 AM by Vilgan »

mr_orange

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #8 on: November 05, 2015, 01:00:07 PM »
Thanks to everyone for your feedback and thoughts.  The post below was particularly detailed so I wanted to address each item as I understand it.  I am not a CPA, but some of the items I have been digging into for a month or so now so I think I have a good idea about how they work.  This mess continues to get more complicated as I peel back the onion though. 


1) Employer part of FICA caps out for LLC taxed as partnership/sole prop, but (to my understanding) as an s-corp its no longer "self employment tax" its more like a regular company with taxes like unemployment tax, FICA, etc. It has to pay your portion of FICA up to the limit irregardless of what your regular w-2 employer has done. You might be able to find a CPA that knows how to avoid paying this.

Yes, finding a magic bullet from a CPA would certainly help, but I am not sure such a thing exists.  The fact that I have to pay the 6.2% in social security tax starting again from $0 through the S-corp is a big deal and alters the decision of what to do considerably. 

2) You are correct about Medicare not capping out, but its not just 2.9% at your income level. There's an additional 0.9% applied once your joint income exceeds 250k. See https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare-Tax . This is (to my understanding) the sum of your w-2 from both sources and your wife's w-2 income from both sources.

Yes, I read about this last night after doing some investigation on other items in this thread.  What is presently unclear to me is whether or not the extra 0.9% applies to ALL income or just the portion over $250k like would be the case for federal taxes.  If anyone knows the answer it would be good to know for the whole analysis.  I'm not sure it will alter decision-making much because 0.9% isn't a lot, but it certainly continues to tip things toward simply minimizing taxes in this tax year instead of looking at things holistically for future years. 

I'll read through the link you have above after I send this message. 

3) You can use the mega backdoor roth trick to shelter up to the 53k limit if you don't hit it already with employee deferral + profit sharing. See https://thefinancebuff.com/after-tax-contributions-in-solo-401k.html . This is after-tax, so great from a tax sheltering perspective but less exciting from a reducing taxes now perspective.

My day job's plan doesn't allow for the mega backdoor trick via Fidelity, but we could change plans for our SoloK.  I originally set my plan up via The Naber's Group, but some folks in town pointed me to Voya and a very knowledgeable TPA that can help out.  I'll continue looking into this option. 

4) You have an overall 53k limit on employee deferrals + employer matching + profit sharing. You should already be able to defer 18k with either income source before worrying about any 25% stuff so the amount you are thinking you need to have as w-2 income is way too high. Even if the taxes are worth it, you only need to shelter 106k - 36k - any employer matching. Assuming no matching, that's 70k, so 280k W-2 from your s-corp not 474k.
The $36k in employee deferrals is completely separate from the $106k for both my wife and I.  I am pretty confident this is the case based on several other threads on this subject.  So to get the independent benefit of the $106k in federal tax savings on 25% of whatever our federal taxes are we'd need to declare $424k (4 * $106k) in earned income unless I am missing something. 

5) solo 401k investing does not need to be as passive. You can invest in real estate or a variety of other things with a solo 401k, but you'd need a self directed 401k rather than the free ones from Fidelity/Vanguard.

Yes....I have a plan like this set up with checkbook control via The Naber's Group.  The point I was making is that I can't actively control the project because this would be an "outside benefit" to the plan.  I would, however, be able to invest passively in deals from other developer buddies of mine or in other things like index funds.  A lot will depend on how we choose to allocate our assets going forward. 

You'd essentially be paying an extra 10% FICA (3.8% medicare after 250k joint and 6.2% employer portion) just to defer taxes to be paid later. That is probably worth it if you are in the 39% bracket, as long as living on a lower income is part of your long term plan.
Yup...all signs point to 10%ish which will be scaled down slightly at lower income levels.  The key really is what the federal tax rate will be in each year.  At 39.6% it is basically a wash (10% total FICA compared with 9.9% federal savings) and at lower levels (say...30%ish) it gets more interesting (10% total FICA compared with 7.5% federal savings == 30% * 25%). 

In general it is hard to plan for things precisely because there are a bunch of moving parts and income from the business is lumpy.  So I don't really know what my true income is going to be for the year.  It seems like the decision is whether or not it makes sense to pay an extra 0.1% to 2.5% in taxes on each dollar in trade for the ability to tax shelter these dollars for N years.  Maybe I am thinking about it too naively, but if my effective tax rate is, say, 25% or so after all the smoke clears on this tax maze nonsense the payback period on each extra dollar taxed (0.1% to 2.5%) should be 4 years.  To me that seems like a favorable bet.  Am I thinking about it the wrong way?

Vilgan

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #9 on: November 05, 2015, 02:25:42 PM »
The $36k in employee deferrals is completely separate from the $106k for both my wife and I.  I am pretty confident this is the case based on several other threads on this subject.  So to get the independent benefit of the $106k in federal tax savings on 25% of whatever our federal taxes are we'd need to declare $424k (4 * $106k) in earned income unless I am missing something.

I'm not sure this is correct, everything I've read/discussed on this matter is that overall limit for 401k contributions is 53k regardless of source (deferral/employer match/profit sharing). Can you point to some other threads that suggest otherwise? If so, I'd love to know about it so I can put more into my own solo 401k since I also have employee income + self employment income this year.

Maybe I am thinking about it too naively, but if my effective tax rate is, say, 25% or so after all the smoke clears on this tax maze nonsense the payback period on each extra dollar taxed (0.1% to 2.5%) should be 4 years.  To me that seems like a favorable bet.  Am I thinking about it the wrong way?

I'm not sure I understand what you are referring to w/ the payback period. The math happens up front, then everything grows in proportion. If you lop off 30% now or wait 10 years and lop off 30% then, it doesn't really matter. The presumed benefit is you avoid lopping of 39% now and instead lop off 25% in the future or whatever. Or if you die, then you lop off a lot less I think (I'm not familiar with what happens to pretax accounts upon death).

mr_orange

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #10 on: November 05, 2015, 02:36:01 PM »
I'm not sure this is correct, everything I've read/discussed on this matter is that overall limit for 401k contributions is 53k regardless of source (deferral/employer match/profit sharing). Can you point to some other threads that suggest otherwise? If so, I'd love to know about it so I can put more into my own solo 401k since I also have employee income + self employment income this year.
http://whitecoatinvestor.com/beating-the-51k-limit-friday-qa-series/

There are other threads on the net if you do some searching.  See this from the IRS site directly too:

http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-401k-and-Profit-Sharing-Plan-Contribution-Limits

The annual additions paid to a participant's account cannot exceed the lesser of:

1. 100% of the participant's compensation, or

2. $52,000 ($57,500 including catch-up contributions) for 2014 ($53,000, or $59,000 including catch-up contributions for 2015).

There are separate, smaller limits for SIMPLE 401(k) plans.

Example 1: Greg, 46, is employed by an employer with a 401(k) plan and he also works as an independent contractor for an unrelated business. Greg sets up a solo 401(k) plan for his independent contracting business. Greg contributes the maximum amount to his employer’s 401(k) plan for 2014, $17,500. Greg would also like to contribute the maximum amount to his solo 401(k) plan. He is not able to make further elective deferrals to his solo 401(k) plan because he has already contributed his personal maximum, $17,500. He has enough earned income from his business to contribute the overall maximum for the year, $52,000. Greg can make a nonelective contribution of $52,000 to his solo 401(k) plan. This limit is not reduced by the elective deferrals under his employer’s plan because the limit on annual additions applies to each plan separately.

Maybe I am thinking about it too naively, but if my effective tax rate is, say, 25% or so after all the smoke clears on this tax maze nonsense the payback period on each extra dollar taxed (0.1% to 2.5%) should be 4 years.  To me that seems like a favorable bet.  Am I thinking about it the wrong way?

I'm not sure I understand what you are referring to w/ the payback period. The math happens up front, then everything grows in proportion. If you lop off 30% now or wait 10 years and lop off 30% then, it doesn't really matter. The presumed benefit is you avoid lopping of 39% now and instead lop off 25% in the future or whatever. Or if you die, then you lop off a lot less I think (I'm not familiar with what happens to pretax accounts upon death).

Well the math happens up front, during the investment period, and at the back.  The time value of money would need to be applied.  I'm assuming our taxes will be very low during the withdrawal period, but it is hard to know what the rate will be during those years.  Looking at it like a project here is what I think the cash flows would look like:

Year 0 Investment - .1% to 2.5% * Earned Income Declared (call it $600k for giggles) == $600 to $15k....call this X
Year 1 Tax Savings - .25X
Year 2 Tax Savings - .25X
.
.
.
Year N Tax Savings - .25X - Withdrawal period tax rate * X

Look close?  So we'd need to save enough in years 1 - N in today's dollars less what we pay in taxes in year N. 

Vilgan

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #11 on: November 05, 2015, 05:50:26 PM »
Holy crap!

If I'm reading this right, this means I can shelter around 78k this year instead of 53k. Wow!

Does this also open up potentially funky territory where you pay your LLC (taxed as partnership) some money from the s-corp in order to have a self employment 53k and an "employer" 53k? Its not a huge deal when thinking about profit sharing since you don't gain anything there, but if you go to the trouble of setting up a mega backdoor roth for both it seems like you could potentially shelter something like 120k per person between employee w-2, s-corp w-2 and self employed w-2.

Note: haven't looked into any of the legal concerns of paying your own company from another company you have a high % ownership in.

As for the 2nd part, I think we agree but are just expressing it/thinking about it differently.

Note on your stuff above btw: If you'd been an LLC taxed as a partnership you wouldn't have to worry about the employer portion having to get paid a 2nd time. Is it too late to change that or fix it or pay yourself a large amount as an independent contractor and subtract it as an expense from the s-corp? Lots of various tactics, no clue on the feasibility of them. S-corp is usually useful for those trying to keep the w-2 portion low, not get it high in order to increase profit sharing.
« Last Edit: November 05, 2015, 05:53:33 PM by Vilgan »

mr_orange

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #12 on: November 05, 2015, 05:58:14 PM »
There are "controlled group" issues you have to look at if you control both entities.  There is a good discussion of this here:

http://www.irafinancialgroup.com/solo-401k-plan-controlled-group-rules-affiliated-service-eligibility.php

I am a minority partner in some other businesses so I think I can actually shelter 1 of every 4 dollars in EACH of those entities.  That is why I am spending so much energy trying to figure all of this out.  It gets pretty complicated.   

mr_orange

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #13 on: November 05, 2015, 06:04:23 PM »
Note on your stuff above btw: If you'd been an LLC taxed as a partnership you wouldn't have to worry about the employer portion having to get paid a 2nd time. Is it too late to change that or fix it or pay yourself a large amount as an independent contractor and subtract it as an expense from the s-corp? Lots of various tactics, no clue on the feasibility of them. S-corp is usually useful for those trying to keep the w-2 portion low, not get it high in order to increase profit sharing.

We are planning to quit our jobs at some point so there really is no sense in flipping the entity types for a small bit of tax planning.  I think in the long term we'll be better off as a S-corp.  As things stand the conversion is basically a wash.  I think the choice will have more to do with asset allocation planning than it will with tax planning. 

Any thoughts and feedback are certainly welcome.  Hopefully this helps you out with sheltering too. 

Vilgan

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Re: SoloK Case Study - Two High W2 Incomes + High Business Income
« Reply #14 on: November 05, 2015, 06:14:02 PM »
There are "controlled group" issues you have to look at if you control both entities.  There is a good discussion of this here:

http://www.irafinancialgroup.com/solo-401k-plan-controlled-group-rules-affiliated-service-eligibility.php

I am a minority partner in some other businesses so I think I can actually shelter 1 of every 4 dollars in EACH of those entities.  That is why I am spending so much energy trying to figure all of this out.  It gets pretty complicated.

For others who read this: there also appear to be ASG issues if the two businesses are intertwined or related in some fashion. So not easy to just create a ton of businesses and shelter 53k in each.