As a self-employed small business owner, you have lots of plates to keep spinning, and lots of additional costs that you never dreamed of when you were employed by someone else (like health insurance, for example). Another cost that you have to deal with when self-employed is Self-Employment tax.
Self-Employment tax (SE tax) is essentially where you are paying both the employER and the employEE portion of the Social Security withholding tax. This means that, in most years, you are taxed at a rate of 12.4% on your first $106,800 of income (double the amount you’d have withheld if you were employed by someone else). This doesn’t count the 2.9% that you also have to withhold for Medicare tax – this is another matter altogether.
[See Jim’s tip on Roth IRA Conversion Planning For Small Business Owners]
Note: for 2011, the rate is reduced by 2% due to the provision in the 2010 Tax Act to stimulate the economy. The rate is presently scheduled to go back up in 2012.
With this in mind, you might wonder if there are ways that you could reduce the tax…? One way might be to incorporate your business and reduce your income by taking dividends for a portion of the otherwise taxable income. By doing this, you would eliminate the Self-Employment tax, and then pay employER withholding and employEE withholding only on each paycheck that you provide yourself. The dividends would not be subject to Social Security tax, since they are not wages.
It’s important to note that such a strategy will have two important factors for you to consider:
- Your earnings record will reflect the new, reduced amounts for income, so your future Social Security benefit will be reduced as well
- You must be careful to pay yourself a reasonable wage, otherwise the IRS will consider your dividends to be taxable as income. It might seem clever to reduce your wages to a very low amount (or eliminate them altogether), but this will come back to haunt you when the IRS gets ahold of your return.
Incorporating your business may be a valid strategy to help reduce your tax costs – for other reasons beyond Social Security tax. But you’ll need to consider all of the consequences before you do this – one of the most important factors being that you will want to increase your retirement savings in order to make up for reduced future Social Security benefits.