S corp salary: tax benefits now vs. less 401K deferral?

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Topic Author
markfaix
Posts: 340
Joined: Sun Jul 06, 2008 5:47 pm

S corp salary: tax benefits now vs. less 401K deferral?

Post by markfaix »

I am a single shareholder of an S Corp. Based on how low I set my salary (within reasonable limits), I can reduce the amount of taxes paid. WIth a lower salary, however, I also decrease the maximum amount of 401K/profit sharing plan deferral I can have.

Which of these options seems best:

Option 1 (lower salary):
Would save $3000 in income tax in 2013 immediately. Max deferral in 401K/profit sharing plan would be $35,000.

Option 2 (higher salary):
Would result in paying $3000 more income tax in 2013. Max deferral in 401K/profit sharing plan would be $51,000.

So basically it's a choice between tax savings now, vs. more room in 401K. If I choose option 1, I would still keep the $16,000 difference in the 401K deferral amounts, but I would not be able to put that money into my 401K.

Fed + state tax bracket is 33%. I plan to donate entire 401K balance to charity upon my and DW's death.
Last edited by markfaix on Mon Jul 08, 2013 10:40 pm, edited 1 time in total.
nordsteve
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Joined: Sun Oct 05, 2008 9:23 am

Re: Low S corp salary: tax benefits now vs. less 401K space?

Post by nordsteve »

If you are certain that you won't need the $$ that you're planning to donate, you could consider using a donor-advised fund in addition to your profit sharing deferral. You'd need to pay attention to the maximum charitable deduction rules to make sure they didn't come into play, based on your particular situation.
ks289
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Joined: Sun Mar 11, 2012 12:42 pm

Re: S corp salary: tax benefits now vs. less 401K deferral?

Post by ks289 »

I assumed that you were taking lower salary but taking more s corporation distribution, but please correct me if I misunderstood.

I am no tax expert, but I did not understand how you end up with more income tax by taking the higher salary and adding $16,000 to the tax deferred space (avoiding up front $5333 in state/federal income tax at 33% combined rate). While taking more as distribution from s corporation you save payroll tax, the s corporation distribution still ends up being taxed at your personal income tax rate.
dhodson
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Joined: Mon May 24, 2010 3:03 pm

Re: S corp salary: tax benefits now vs. less 401K deferral?

Post by dhodson »

it appears that what you are doing is considering paying yourself 100k less in salary in order to save 2.9%?

not taking into consideration if the reduced salary is appropriate or not, it seems like you would have to decide what you think your tax rate will be in the future. If you plan on saving a truck load and/or you believe taxes will go higher then might be best to save the 2.9% now and use taxable given the flexibility and ability to tax/loss harvest as well as capital gains (assuming you have already maxed out backdoor roth). If your main goal is to save for retirement then id personally say go for the higher deferal just to avoid all the issues.
SeattleCPA
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Joined: Fri Jul 06, 2012 7:06 pm

Re: S corp salary: tax benefits now vs. less 401K deferral?

Post by SeattleCPA »

markfaix wrote:... So basically it's a choice between tax savings now, vs. more room in 401K...
I think you want to be really precise in your language here... it'll help you with your analysis. E.g., you're really not "saving" you're deferring or delaying and (in effect) hoping to pay a lower tax rate later on. But there's a cost to this tactic... that medicare tax or FICA tax or even medicare surtax

Here's one simple way to think about this. If you pay an extra $3,000 now to bump up deferral from $30K to to $50K so you can delay paying the $6666 tax on that last $20K of income, you do "net" cash of roughly $3666 this year.... but you'll pay taxes on the $20,000 when you later draw or are forced to RMD.

You may make money by doing this. But it's not a sure bet in my eyes. Presumably you will pay some tax when you draw the money out... if the tax rate at withdrawal is half your rate now, you'll about be break-even. I.e., ignoring for time being the time value of the deferral, you will pay $3K now to avoid paying $6666 in taxes currently but you will have to pay maybe $3333 in taxes in the end anyway.

BTW, whenever I work out this sort of math for my own pension fund calculations, I never find the option of bumping up my salary to max out my pension attractive.
Topic Author
markfaix
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Joined: Sun Jul 06, 2008 5:47 pm

Re: S corp salary: tax benefits now vs. less 401K deferral?

Post by markfaix »

@ks289:
You are correct that I'm thinking about reducing S corp salary and increasing S corp distributions. Reducing S corp salary reduces tax by 2.9% (ie Medicare tax). But the way our pension plan is set up, a lower salary reduces the maximum 401K contribution by 15%. So lower S corp salary -> lower 401K deferral -> higher net income taxes (income tax on money not in 401K > Medicare tax saved).

@dhodson:
Your analysis was correct and very helpful. Thank you.
Topic Author
markfaix
Posts: 340
Joined: Sun Jul 06, 2008 5:47 pm

Re: S corp salary: tax benefits now vs. less 401K deferral?

Post by markfaix »

SeattleCPA wrote:
markfaix wrote:... So basically it's a choice between tax savings now, vs. more room in 401K...
I think you want to be really precise in your language here... it'll help you with your analysis. E.g., you're really not "saving" you're deferring or delaying and (in effect) hoping to pay a lower tax rate later on. But there's a cost to this tactic... that medicare tax or FICA tax or even medicare surtax

Here's one simple way to think about this. If you pay an extra $3,000 now to bump up deferral from $30K to to $50K so you can delay paying the $6666 tax on that last $20K of income, you do "net" cash of roughly $3666 this year.... but you'll pay taxes on the $20,000 when you later draw or are forced to RMD.

You may make money by doing this. But it's not a sure bet in my eyes. Presumably you will pay some tax when you draw the money out... if the tax rate at withdrawal is half your rate now, you'll about be break-even. I.e., ignoring for time being the time value of the deferral, you will pay $3K now to avoid paying $6666 in taxes currently but you will have to pay maybe $3333 in taxes in the end anyway.

BTW, whenever I work out this sort of math for my own pension fund calculations, I never find the option of bumping up my salary to max out my pension attractive.

SeattleCPA,

Thanks for your helpful response, and for your information website.

Not to make things more complicated, but how do you handle the time value of the deferral? I'm only in my late 30s, so that's an important part of the calculation.
SeattleCPA
Posts: 456
Joined: Fri Jul 06, 2012 7:06 pm

Re: S corp salary: tax benefits now vs. less 401K deferral?

Post by SeattleCPA »

Hi Mark,

I tried to write up a general approach for doing the analysis you ask about... before I got into the topic more than a little way, I had 1000 words of content and an Excel spreadsheet. So I'm going to post link to my blog where I provide the steps:

http://evergreensmallbusiness.com/pensi ... oll-taxes/

I''ll upload a spreadsheet there that'll let you and others do the math. But based on your earlier input values, I would say that with numbers like yours, the pension is mildy attractive... but not super-compelling.

BTW, the approach I think one can use (and this may be a little debatable) is to look at the after-tax future values you end up with. This approach exaggerates the differences (because it future values the difference two or three decades into the future). But it at least lets you see which option looks better with a given set of assumptions.

Steve
Topic Author
markfaix
Posts: 340
Joined: Sun Jul 06, 2008 5:47 pm

Re: S corp salary: tax benefits now vs. less 401K deferral?

Post by markfaix »

Wow, Steve, thanks for the thorough analysis! I ran multiple scenarios in your spreadsheet. Using multiple assumptions, my takehome points are

1. If the reasonable salary is above the FICA limit, it's a close decision to take a low S corp salary vs take a higher S corp salary w/full pension funding. Steve detailed the mitigating factors in his concluding paragraphs.

2. If the reasonable salary is below the FICA limit, you should take the lowest reasonable salary possible; saving FICA outweighs the tax savings of more pension deferral.
SeattleCPA
Posts: 456
Joined: Fri Jul 06, 2012 7:06 pm

Re: S corp salary: tax benefits now vs. less 401K deferral?

Post by SeattleCPA »

I think you've accurately summarized the situation Mark. Good luck with your decisions. :sharebeer
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