Mega Backdoor Roth vs Payroll Tax in S Corp

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Topic Author
patchy
Posts: 7
Joined: Sat Feb 21, 2015 12:09 pm

Mega Backdoor Roth vs Payroll Tax in S Corp

Post by patchy »

Hi Bogleheads,

I have a S-Corp in which it had about 65,000 of profits (before paying any wages) and I want to see whether I should mega-backdoor as much as I can ($58,000) or if I should try to minimize W-2 and save on payroll taxes. In other words, how much is Roth contribution worth? (Please see my question near bottom if you want to skip the details)

Edit to add: This S-Corp is a side project and I have a separate full time job that I put pre-tax employee contributions of $19,500.

Below I try to find the difference between two options.

State: CA
Marginal tax rate: 24%
CA marginal tax rate: 9.3%

Scenario #1:
Contribute the max to backdoor Roth
W-2 wages: 58,000
Payroll Tax (ER): 4,682
Payroll Tax (EE): 4,437
S-Corp Profits: 2,318
QBI deduction : 464
QBI savings: $111 (QBI deduction * marginal Federal tax rate)

Total amount in 1040: W-2 wages + S Corp profits = 58,464

Scenario #2:
Pay just the S-Corp reasonable wage
W-2 wages: 20,000
Payroll Tax (ER): 1,775
Payroll Tax (EE): 1,530
S-Corp Profits: 43,225
QBI deduction: 8,645
QBI savings: $2,075 (QBI deduction * marginal Federal tax rate)

Total amount in 1040: W-2 wages + S Corp profits = 63,225

Scenario #1
Amount to backdoor Roth: 58,000
Payroll tax (EE + ER) + QBI savings = $9,008

Scenario #2
Amount to backdoor Roth: 20,000
Payroll tax (EE + ER) + QBI savings = $1,230

Difference in 1040 amount: 4761
At marginal rate (24%+9.3%) = $1,585

Difference between #1 and #2:
$9,008 - $1,230 - 1,585 = 6,193

Question: :?:

Is an additional $38,000 in Roth contribution worth $6,193? (If we assume my calculations are correct)
-> My first instinct is "no way!" but I wanted to see if I am missing anything.
If I hold onto it for a long time, maybe eventually it #1 will catch up with the tax savings?
Of course, this would depend on the market returns. And the $6,193 would grow on its own in a taxable account if I go with #2.

Lastly, I believe this is the last year for mega-backdoor Roth so I may not get much chance to contribute a large amount again.

Some hard to figure benefits I didn't consider:
- Higher W-2 = higher SS taxes & contribution
Last edited by patchy on Wed Oct 13, 2021 12:36 am, edited 1 time in total.
fyre4ce
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Joined: Sun Aug 06, 2017 11:29 am

Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by fyre4ce »

I’ll look at this in more detail in the morning. But I have a few questions to start.

How many years before you retire? Do you plan to retire in CA, or elsewhere?

Do you have another W-2 job where you use up your elective deferral?

Do you prefer pre-tax or Roth in general? (Ie. at your normal marginal rate) If you don’t have another elective deferral you could contribute $19.5k as traditional and the rest as Roth, if you prefer.

I noticed in your low-salary case you are not contributing the 25% of wages as employer per-tax contributions. Any reason why?

Also check out the Solo 401k section here: https://www.bogleheads.org/wiki/Mega-backdoor_Roth
Lee_WSP
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Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by Lee_WSP »

First of all, I can't see how you can claim a salary less than the minimum wage for a full time job. Given the overall profits, this does not pass the smell test even if it were a part time position.

Secondly, the value of the Roth is the difference in taxes you would have paid had you not done the Roth.
Topic Author
patchy
Posts: 7
Joined: Sat Feb 21, 2015 12:09 pm

Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by patchy »

fyre4ce wrote: Wed Oct 13, 2021 12:23 am I’ll look at this in more detail in the morning. But I have a few questions to start.

How many years before you retire? Do you plan to retire in CA, or elsewhere?

Do you have another W-2 job where you use up your elective deferral?

Do you prefer pre-tax or Roth in general? (Ie. at your normal marginal rate) If you don’t have another elective deferral you could contribute $19.5k as traditional and the rest as Roth, if you prefer.

I noticed in your low-salary case you are not contributing the 25% of wages as employer per-tax contributions. Any reason why?

Also check out the Solo 401k section here: https://www.bogleheads.org/wiki/Mega-backdoor_Roth
Thank you for taking a look!
Sorry yes, I forgot to include in the post but I have another W-2 which I put 19,500 in a 401(k).

I didn't consider the 25% employer contribution on either scenarios because it seems to reduce the S-Corp profits, which reduces QBI deduction, so I feel like it is not worth it in this case.

I don't have a strong preference either way for pre-tax or Roth; my 401(k) at the day job only had pre-tax until very recently so I always maxed it out as pre-tax and contributed to Roth in the IRA.

I'll take another look at the wiki - I don't fully understand some of the examples yet.
Lee_WSP wrote: Wed Oct 13, 2021 12:26 am First of all, I can't see how you can claim a salary less than the minimum wage for a full time job. Given the overall profits, this does not pass the smell test even if it were a part time position.

Secondly, the value of the Roth is the difference in taxes you would have paid had you not done the Roth.
I'm sorry, I didn't mention that this was a "side-job" S-Corp so I don't work on it full time. I have a separate full time job that I spend most of my time at.
Luckywon
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Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by Luckywon »

patchy wrote: Wed Oct 13, 2021 12:35 am
Sorry yes, I forgot to include in the post but I have another W-2 which I put 19,500 in a 401(k).
If this is the case, isn't the maximum amount of MBR you can do through your solo 401k $38,500? My understanding is you cannot make Roth employee deferrals in your solo 401k if you have made a $19,500 employee deferral via your regular employment.
Luckywon
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Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by Luckywon »

patchy wrote: Wed Oct 13, 2021 12:35 am
I didn't consider the 25% employer contribution on either scenarios because it seems to reduce the S-Corp profits, which reduces QBI deduction, so I feel like it is not worth it in this case.
Agree with this. If you are in QBI territory, to the extent you favor MBR over pretax contributions, you are effectively getting a discount on a Roth conversion. The discount may be enough to favor MBR over pretax contributions. I have decided to make all my 401K contributions Roth this year for this reason.
fyre4ce
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Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by fyre4ce »

One way I have approached this problem in the past is to calculate an after-tax multiplier for different tax categories. For example, let's assume you plan on retiring in 25 years, and expect an 8% return, 2% yield, 90% of which is qualified. Let's also assume you will be in the 24% bracket (15% LTCG/QD) in retirement, but in a tax-free state.

A Roth dollar invested today will be worth (1+8%)^25 = 6.848

A pre-tax dollar invested today will be worth (1+8%)^25 * (1-24%) = 5.205

Calculating the value of a taxable dollar is a bit more complex. The average dividend tax rate will be 90% * (15%+9.3%) + 10% * (24%+9.3%) = 25.2%

The pre-tax value of a taxable dollar will be (1 + 8% - [2% * 25.2%])^25 = 6.093

The future basis per taxable dollar today will be 1 + (2% * (1 - 25.2%) / (8% - 2% * 25.2%)) * (6.093 - 1) = 2.016

The future after-tax value will be 6.093 - (6.093 - 2.016) * 15% = 5.481

=============================================

Moving to your scenarios, the payroll tax numbers look a little strange but let's go with them.

Scenario 1:
Gross earnings: $65,000
Payroll taxes: $4,682 + $4,437 = $9,119
Taxable income: $58,000 + $2,318 - $464 = $59,854
Total taxes owed: $59,854 * (24% + 9.3%) + $9,119 = $29,050
Roth contributions: $58,000
Taxable contributions: $65,000 - $58,000 - $29,050 = negative $22,050 (that this number is negative means you will need to bring in funds from an external source (ie. your other income) to cover the tax cost of this strategy)
Total future value: $58,000 * 6.848 - $22,050 * 5.481 = $276,348

Scenario 2:
Gross earnings: $65,000
Payroll taxes: $1,775 + $1,530 = $3,305
Taxable income: $20,000 + $43,225 - $8,645 = $54,580
Total taxes owed: $54,580 * (24% + 9.3%) + $3,305 = $21,480
Roth contributions: $20,000
Taxable contributions: $65,000 - $20,000 - $21,480 = +$23,520
Total future value: $20,000 * 6.848 + $23,520 * 5.481 = $265,887

So, it looks like the higher salary is better, but only by a small bit (~4%). Also consider that scenario 2 gives you ~$46k more in taxable money, which has a liquidity advantage to the Roth.

I wouldn't be so quick to dismiss the pre-tax contribution option, even at a loss of 199A deduction. You pay a high tax rate in CA now, and most people have a lower tax rate in retirement than they do when working, both due to lower taxable income and also by sometimes living in a lower-tax state. I ran a Scenario 3 that maximizes employer pre-tax contributions:

Scenario 3:
Gross earnings: $65,000
Wages: $48,800
Payroll taxes: $3,978 + $3,733 = $7,711
Employer pre-tax contribution: $12,200
Net business income: $65,000 - $48,800 - $3,978 - $12,200 = $22
Taxable income: $48,800 + $22 - $4 = $48,817
Total taxes owed: $48,817 * (24% + 9.3%) + $7,711 = $23,968
Roth contributions: $58,000 - $12,200 = $45,800
Taxable contributions: $65,000 - $45,800 - $12,200 - $23,968 = -$16,968
Total future value: $45,800 * 6.848 + $12,200 * 5.205 - $16,968 * 5.481 = $284,156

Check my math, but it looks like trying to prioritize pre-tax contributions is the way to go.
Last edited by fyre4ce on Wed Oct 13, 2021 1:32 pm, edited 1 time in total.
Lee_WSP
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Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by Lee_WSP »

patchy wrote: Wed Oct 13, 2021 12:35 am
I'm sorry, I didn't mention that this was a "side-job" S-Corp so I don't work on it full time. I have a separate full time job that I spend most of my time at.
While there is case law and irs opinions on this, the reasonable salary standard basically means you need to be able to find someone else willing and able to do the work you're paying yourself to do at the rate you are paying yourself to do it at.

High wage part time work actually typically pays higher per hour than someone who is salaried in that position.

Proceed with caution. It's still your choice.
Lee_WSP
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Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by Lee_WSP »

fyre4ce wrote: Wed Oct 13, 2021 11:17 am One way I have approached this problem in the past is to calculate an after-tax multiplier for different tax categories. For example, let's assume you plan on retiring in 25 years, and expect an 8% return, 2% yield, 90% of which is qualified. Let's also assume you will be in the 24% bracket (15% LTCG/QD) in retirement, but in a tax-free state.

A Roth dollar invested today will be worth (1+8%)^25 = 6.848

A pre-tax dollar invested today will be worth (1+8%)^25 * (1-24%) = 5.205

Calculating the value of a taxable dollar is a bit more complex. The average dividend tax rate will be 90% * (15%+9.3%) + 10% * (24%+9.3%) = 25.2%

The pre-tax value of a taxable dollar will be (1 + 8% - [2% * 25.2%])^25 = 6.093

The future basis per taxable dollar today will be 1 + (2% * (1 - 25.2%) / (8% - 2% * 25.2%)) * (6.093 - 1) = 2.016

The future after-tax value will be 6.093 - (6.093 - 2.016) * 15% = 5.481

=============================================
Don't happen to have that in an excel sheet you'd be willing to share do you? :beer :sharebeer

edit: It was easy enough to plug in. So, based on a range of interest rates, years, and tax brackets, the Roth dollar is worth approximately 1.05x - 1.25x a taxable dollar.
Last edited by Lee_WSP on Wed Oct 13, 2021 11:58 am, edited 1 time in total.
Luckywon
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Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by Luckywon »

fyre4ce wrote: Wed Oct 13, 2021 11:17 am Let's also assume you will be in the 24% bracket (15% LTCG/QD) in retirement, but in a tax-free state.
Wow very interesting analysis especially with regard to how pre-tax contributions seem to be advantageous over Roth.

Any chance you could run the numbers assuming remaining in 9.3% state after retirement?
pizzy
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Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by pizzy »

https://proconnect.intuit.com/tax-refor ... alculator/

Use this and just focus on the S-Corp column since it seems the S-Corp decision was already made. Compare the two scenarios by changing the inputs and see what nets you more money
fyre4ce
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Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by fyre4ce »

Lee_WSP wrote: Wed Oct 13, 2021 11:33 am
fyre4ce wrote: Wed Oct 13, 2021 11:17 am One way I have approached this problem in the past is to calculate an after-tax multiplier for different tax categories. For example, let's assume you plan on retiring in 25 years, and expect an 8% return, 2% yield, 90% of which is qualified. Let's also assume you will be in the 24% bracket (15% LTCG/QD) in retirement, but in a tax-free state.

A Roth dollar invested today will be worth (1+8%)^25 = 6.848

A pre-tax dollar invested today will be worth (1+8%)^25 * (1-24%) = 5.205

Calculating the value of a taxable dollar is a bit more complex. The average dividend tax rate will be 90% * (15%+9.3%) + 10% * (24%+9.3%) = 25.2%

The pre-tax value of a taxable dollar will be (1 + 8% - [2% * 25.2%])^25 = 6.093

The future basis per taxable dollar today will be 1 + (2% * (1 - 25.2%) / (8% - 2% * 25.2%)) * (6.093 - 1) = 2.016

The future after-tax value will be 6.093 - (6.093 - 2.016) * 15% = 5.481

=============================================
Don't happen to have that in an excel sheet you'd be willing to share do you? :beer :sharebeer

edit: It was easy enough to plug in. So, based on a range of interest rates, years, and tax brackets, the Roth dollar is worth approximately 1.05x - 1.25x a taxable dollar.
I cleaned up the spreadsheet and posted it here: https://docs.google.com/spreadsheets/d/ ... ue&sd=true Enjoy!

I assumed a 25 year investment period, which was a WAG, OP didn't say how old he was or when he would retire. Assuming living in CA and retiring in a tax-free state, the "Roth/taxable value ratio" can be anywhere from 1.12:1 at 10 years to 1.36:1 at 40 years. Assuming retiring in CA, the ratio is 1.16:1 at 10 years, and 1.48:1 at 40 years.
Last edited by fyre4ce on Wed Oct 13, 2021 2:01 pm, edited 1 time in total.
fyre4ce
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Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by fyre4ce »

Luckywon wrote: Wed Oct 13, 2021 11:50 am
fyre4ce wrote: Wed Oct 13, 2021 11:17 am Let's also assume you will be in the 24% bracket (15% LTCG/QD) in retirement, but in a tax-free state.
Wow very interesting analysis especially with regard to how pre-tax contributions seem to be advantageous over Roth.

Any chance you could run the numbers assuming remaining in 9.3% state after retirement?
Cleaned up spreadsheet is here: https://docs.google.com/spreadsheets/d/ ... ue&sd=true

I made a couple improvements. I don't think the payroll taxes were calculated properly, and also the 199a deduction applies only to federal income taxes, not state. With a future 24% tax rate, the future values are $273,893 for scenario 1, $261,344 for scenario 2, and $282,226 for scenario 3.

Assuming the OP retires in CA and stays in the 24% bracket, the future values are $282,422, $252,742, and $280,984 for scenarios 1-3 respectively. The higher withdrawal tax rate brings down the performance of the pre-tax option, very slightly below scenario 1. Scenario 2 does poorly, because CA state taxes are assumed on any taxable withdrawals, which favors getting as much into retirement accounts as possible.

I'd also want to make sure that the OP has good reason for thinking he'll retire in the 24% bracket. That requires many millions in pre-tax accounts to get taxable income that high. Typically most investors in the middle-to-high income range will be in a lower bracket in retirement. In a separate thread I posted an awesome (IMO) tool for estimating future tax rates. This would be a good chance to take it for a test-drive. If OP wants help with it, please let me know.
Luckywon
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Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by Luckywon »

fyre4ce wrote: Wed Oct 13, 2021 1:54 pm
Luckywon wrote: Wed Oct 13, 2021 11:50 am
fyre4ce wrote: Wed Oct 13, 2021 11:17 am Let's also assume you will be in the 24% bracket (15% LTCG/QD) in retirement, but in a tax-free state.
Wow very interesting analysis especially with regard to how pre-tax contributions seem to be advantageous over Roth.

Any chance you could run the numbers assuming remaining in 9.3% state after retirement?
Cleaned up spreadsheet is here: https://docs.google.com/spreadsheets/d/ ... ue&sd=true

I made a couple improvements. I don't think the payroll taxes were calculated properly, and also the 199a deduction applies only to federal income taxes, not state. With a future 24% tax rate, the future values are $273,893 for scenario 1, $261,344 for scenario 2, and $282,226 for scenario 3.

Assuming the OP retires in CA and stays in the 24% bracket, the future values are $282,422, $252,742, and $280,984 for scenarios 1-3 respectively. The higher withdrawal tax rate brings down the performance of the pre-tax option, very slightly below scenario 1. Scenario 2 does poorly, because CA state taxes are assumed on any taxable withdrawals, which favors getting as much into retirement accounts as possible.

I'd also want to make sure that the OP has good reason for thinking he'll retire in the 24% bracket. That requires many millions in pre-tax accounts to get taxable income that high. Typically most investors in the middle-to-high income range will be in a lower bracket in retirement. In a separate thread I posted an awesome (IMO) tool for estimating future tax rates. This would be a good chance to take it for a test-drive. If OP wants help with it, please let me know.
Thank you so much, I'm wrestling with how to allocate S Corp W2 wages, profit, pre-tax and Roth contributions as well. Very challenging. Your approach and spreadsheet are a fantastic springboard!!
fyre4ce
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Joined: Sun Aug 06, 2017 11:29 am

Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by fyre4ce »

Luckywon wrote: Wed Oct 13, 2021 2:23 pm
fyre4ce wrote: Wed Oct 13, 2021 1:54 pm
Luckywon wrote: Wed Oct 13, 2021 11:50 am
fyre4ce wrote: Wed Oct 13, 2021 11:17 am Let's also assume you will be in the 24% bracket (15% LTCG/QD) in retirement, but in a tax-free state.
Wow very interesting analysis especially with regard to how pre-tax contributions seem to be advantageous over Roth.

Any chance you could run the numbers assuming remaining in 9.3% state after retirement?
Cleaned up spreadsheet is here: https://docs.google.com/spreadsheets/d/ ... ue&sd=true

I made a couple improvements. I don't think the payroll taxes were calculated properly, and also the 199a deduction applies only to federal income taxes, not state. With a future 24% tax rate, the future values are $273,893 for scenario 1, $261,344 for scenario 2, and $282,226 for scenario 3.

Assuming the OP retires in CA and stays in the 24% bracket, the future values are $282,422, $252,742, and $280,984 for scenarios 1-3 respectively. The higher withdrawal tax rate brings down the performance of the pre-tax option, very slightly below scenario 1. Scenario 2 does poorly, because CA state taxes are assumed on any taxable withdrawals, which favors getting as much into retirement accounts as possible.

I'd also want to make sure that the OP has good reason for thinking he'll retire in the 24% bracket. That requires many millions in pre-tax accounts to get taxable income that high. Typically most investors in the middle-to-high income range will be in a lower bracket in retirement. In a separate thread I posted an awesome (IMO) tool for estimating future tax rates. This would be a good chance to take it for a test-drive. If OP wants help with it, please let me know.
Thank you so much, I'm wrestling with how to allocate S Corp W2 wages, profit, pre-tax and Roth contributions as well. Very challenging. Your approach and spreadsheet are a fantastic springboard!!
Thanks. It's almost as if I've done this calculation before :wink:
Topic Author
patchy
Posts: 7
Joined: Sat Feb 21, 2015 12:09 pm

Re: Mega Backdoor Roth vs Payroll Tax in S Corp

Post by patchy »

Wow!! fyre4ce, thank you for your comments and putting together the Excel file! I will play around with the numbers and study the outcomes. I'll need some time to digest everything. Thank you for the link to your tool for estimating the retirement tax rate too. You're right that it'll probably be lower than the my current marginal tax rate.

I don't know where I'll be retiring yet, but California is probably the best guess at this point. I am in my early 30s so I still have a lot of time until traditional retirement age.

I think from your examples, no scenario is TOO much better or worse than the alternatives, which gives me some peace of mind!

I still have a few months to decide so I'll study more in depth. Thank you again fyre4ce and everyone else for your thoughtful comments!! :happy
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