Jim Dahle, the physician who edits the White Coat Investor blog, hypothesized a week or so ago that it might make sense to add your spouse to a small business as a partner or employee in order to bump the family’s pension fund contributions.
His blog post, which you can read here, lists a bunch of hard and soft reasons for this idea. Nearly all of which I agree with. But his post started a friendly discussion between the two of us about accounting for the relative tax costs and tax benefits of this choice.
The math gets a little, well, boring. But the discussion is a really good one to have. It applies to every married small business owner wondering if he or she should add a spouse to the payroll in order to get the spouse (and the family) a bigger pension.
Accordingly, I’m going to describe the practical situation Jim and I talked about and then present some numbers that show it’s hard to make the tax benefits work the way you want them to work.
The Example We’ll Look At
We need an example to make the discussion concrete. So let me create this simplified fictional situation inspired by the financial picture Dr. Dahle shares at his blog.
Assume you’re a highly-compensated professional with an income that already puts you into the top marginal tax bracket. We’ll assume this “first” job provides you with something like a 401(k) plan. Further assume that you find yourself with the good luck to have another business that generates $400,000 a year in profits.
In this case, you sort of have two choices. You can probably use the $400,000 of business profit to make a single SEP-IRA deduction for yourself. The maximum is $53,000 for 2016.
Or you can share the compensation with your spouse meaning that you can split the $400,000 of earnings into two $200,000 slices. And in this case, you guys can save close to $80,000, or roughly about $40,000 each into a SEP-IRA.
The rub with this second option is that it means the business may need to pay a 12.4% Social Security on your spouse’s first $118,000 of income. And this extra FICA adds up to nearly $15,000 of tax.
You see the trade-off, right? Bigger pension fund contribution and so more tax deferral… but a giant hit from the extra Social Security taxes you’ll pay.
Calculating the Annual Savings
I constructed an Excel scratchpad workbook that estimates the savings you accumulate if you save as much of the $400,000 as you can, enjoy good fortune over 25 years, and earn a real rate of return of five percent.
I’m going to present several simple tables that summarize the calculations. But let me first share two thoughts about the taxes you pay on your taxable accounts.
First, though you will need to pay income taxes on the dividends you earn on your taxable account, note that the tax rate on qualified dividends will be lower than your marginal rate. (Probably about 50% less.) Further, you might choose a mutual fund that focuses on growth stocks, which means low or no dividends. Or you might invest in an international stock mutual fund which will give you foreign tax credits (on the foreign stock dividends) which may wipe out a big chunk of the tax on your dividends. (In my scratchpad calculations, I assume the tax rate on any dividends equals 25%, but for the reasons just mentioned I think this may overstate the taxes.)
Second, the scratchpad calculations assume that you don’t realize capital gains, or least not much, because you’re investing in something like an index fund which you can just let roll and roll far into the future.
You may disagree with my “tax-lite” way of investing, but if you invest in that manner, you may enjoy a savings program that looks something like that shown in the table below if you save whatever portion of the $400,000 is leftover after paying any payroll and income taxes.
Note: The calculations that follow assume the income tax rate is the federal top rate of 39.6% and that the payroll taxes rates are that 3.8% Medicare tax and, on the first $118,000 of your spouse’s share of the business profit, an additional 12.4% FICA tax.
|Amount||One Participant||Two Participants|
|Pretax income to save||$400,000||$400,000|
|Leftover to save||$347,000||$322,623|
|Less: income taxes on leftover||$135,115||$122,565|
|Less: payroll taxes||$15,200||$29,832|
Let me highlight the key bits shown in the table above. With one SEP, you save $53,000 into your SEP and then have about $197,000 after taxes for additional savings. With two SEPs, you save $77,377 into your SEP accounts and have about $170,000 after taxes for additional savings.
Note: I was a little rough in my calculations of the how the employer component of the payroll taxes saves you money on income taxes and payroll taxes. Er, sorry…
Forecasting the Accumulations
Once you have the savings amounts calculated, it’s straight forward to use a spreadsheet like Microsoft Excel to forecast future values.
The table that follows shows the future values I estimated. Note that the table not only shows the future value of the taxable savings but breaks those balances into components: original contributions, already taxed dividends that have been reinvested, and appreciation that hasn’t yet been taxed but will be when you liquidate the portfolio:
|Amount||One Participant||Two Participants|
|Future value of SEP(s)||$2,529,536||$3,692,970|
|Future value taxable||$8,765,299||$7,586,173|
Annuitizing the Savings Over Retirement
With the future values in hand, it’s pretty easy to calculate the payments that annuitize these amounts over your retirement. If you draw down your balances over thirty years of retirement, for example, the annual payout looks like that shown in the next table.
|Amount||One Participant||Two Participants|
|Capital gains and dividend taxes||$76,618||$66,311|
|After-tax taxable annuity||$493,578||$427,181|
|Regular income tax||$65,162||$95,132|
|After-tax SEP annuity||$99,388||$145,101|
|Total combined after-tax income||$592,966||$572,281|
Okay, the key takeaway from the preceding table? Well, on an after-tax basis, you end up with about $20,000 more income each year if you use a single SEP account.
Note that I’ve calculated the ordinary income taxes and capital gains and qualified dividend taxes I’m guessing you’ll pay using the top marginal rate used for the accumulation phase. This is a little sloppy, I agree. But this little shortcut should be overstating the tax burden by the same amount for both pension plan options because in this scenario we’re assuming you’re well into the top tax bracket. Note too that the income shown above isn’t per the example your only income. You’ll also be drawing down the 401(k) from your regular job. And you’ll be enjoying Social Security benefits.
Summarizing the Situation
So the preceding paragraphs present a very specialized situation… a situation sort of like that discussed at the White Coat Investor blog. But what you see here hints at some common realities. Let me quickly summarize what seem to me to be the key points.
First point: Adding your spouse to your business as a co-owner or employee absolutely does bump your pension contribution and the tax deferral from the contribution. No doubt. Accordingly, if you really need to catch up with your pension, you maybe want to add a spouse to the business. In a sense, who cares about the taxes in this situation. You need to focus on saving.
Note: If you’re really light on the amounts you’ve accumulated in your retirement accounts, your tax rate in retirement will be really low and so tax deferred options make a lot more sense than they do in the scenario presented above. (See here for a longer discussion about why the numbers work out this way.)
Second point: The payroll taxes you pay are brutal if you do add a spouse and he or she needs to pay the 12.4% FICA tax. In many cases—including the scenario provided in the preceding paragraphs—you don’t save money by adding a spouse.
Note: In the example situation discussed in this post, note that while you bump your pension fund contributions by about $30,000, you pay about an extra $15,000 to do so. That nearly 50% “load” eats up any benefit of the deferral.
Third point: You can often create very tax-efficient taxable savings programs. Obviously, long-term capital gains and qualified dividends receive preferential tax treatment, for example. You largely control when (and even if) you realize capital gains. You may be able to use foreign tax credits in a taxable account that are not otherwise available to you in a tax-deferred account and these credits can in effect pay a big chunk of your US income taxes. Further, and not to be too negative, but if you leave a taxable account to your heirs, the step-up in basis at your death will eliminate the potential capital gains taxed baked into your taxable portfolio.
A fourth point: Putting your spouse on the payroll might result in your family ultimately getting bigger Social Security benefits. But you want to do the math on this. Remember that a spouse will automatically get the option of a benefit equal to half of yours. Accordingly, best case, you’ll pay full price for Social Security benefits but only get half a benefit.
Some Other Retirement Related Posts
If you found this post useful, you might also find these semi-related posts interesting:
Real Estate vs IRA and 401(k) Accounts: Part I I am not a big fan of direct real estate investment, but one has to admit that real estate provides some spectacular tax benefits as compared to things like IRAs and 401(k) accounts…
$10,000,000 IRAs and 401(k)s Possible? A look at the absolute best-case outcomes possible with retirement style accounts shows you can accumulate a lot… but not as much as some people hope.
Worst-case Scenarios for Roth-style Accounts One of the posts in a three-part series I did about the common practical problems with using Roth-style retirement accounts.