How do I calculate the marginal lifetime cost and benefit of a FICA contribution? This calculation applies when determining how to structure a business, such as whether a single-member LLC should be taxed as a sole proprietorship or as an S Corporation. With the S Corporation, a portion of the income can be treated as a distribution, which is not subject to FICA tax (Social Security and Medicare) but also doesn't contribute to your earning history used to calculate your social security payments at retirement.

How do you calculate how the cost of higher taxes in the moment compares to the benefit of higher payments in retirement?

  • Is there going to be an associated 401(k) plan? It adds a whole new dimension to the analysis, as you have two new options of "pay FICA and make an employer contribution", "pay FICA and make an employee contribution" in addition to "pay FICA and income tax" vs "take a distribution and pay income tax but not FICA" – Ben Voigt Jan 1 at 18:19
  • @BenVoigt When I wrote the question, I didn't consider a 401(k). A thorough answer could include variables for the scenarios you mentioned, however. – Edward Brey Jan 1 at 20:48

To calculate the marginal benefit in retirement of a structure that includes FICA tax versus one that avoids it, first compute a marginal benefit from a given income amount that would be impacted by the business structure. Running alongside the following calculation instructions is an example based on $1 of marginal income and other various stated assumptions, which you can replace based on your own situation. Another assumption is that the 2019 tax and social security rules never change – not realistic, but useful for getting a sense of the numbers.

  1. Marginal retirement benefit. Your retirement benefit is based on bracketed percentage of your average lifetime earnings. Your Retirement Benefit: How It’s Figured from the Social Security Administration (SSA) shows the calculation. Example calculation, assuming the 32% benefit bracket (and the $1 income under consideration): $1 * 32% = $0.32.

The above retirement benefit is annual. To convert it to a lifetime benefit, multiply by the years in retirement. For example, the SSA estimates the average lifespan for a 40-year-old male at another 38.59 years. Subtracting the sum from the retirement age of 66.5 leaves 12 years of retirement, assuming your longevity is average. The example lifetime retirement benefit then is $0.32 × 12 = $3.84.

To comparatively calculate the marginal FICA self-employment taxes, add the following amounts. The examples assume a 24% tax bracket.

  1. FICA self-employment tax. The tax rate is 15.3% assuming your income level doesn't trigger 0.9 percent Medicare surtax. Half the self-employment tax serves as a deduction, which decreases the effective tax. Example calculation: $1 × (15.3% − 15.3% ÷ 2 × 24%) = $0.1346.

  2. Qualified Business Income (QBI) deduction. Assumes your business type and income level leave you qualified for this 20% deduction now that you have pass-through income instead of a distribution. Example calculation (uses a negative number, since it lowers your tax): $1 × −(24% × 20%) = −$0.048

  3. Loss of tax deductions on retirement savings. The government saves the tax you pay for your retirement. This means that to keep your overall retirement savings equal, save an equivalent amount less in your IRA or other saving vehicle. Otherwise, you'll over-save, assuming you were initially saving the optimal amount. (If you were under-saving before, for example, if your lifetime cash flow optimizes with a maxed out IRA plus the FICA tax, then skip this part of the calculation.)

    The amount to decrease savings by is the marginal lifetime retirement benefit amount divided by working years, which the SSA sets as 35. The amount to decrease should be inflated by the better performance of individual investment relative to the SSA's average wage index. The example assumes 5%. The inflated decrease reduces your retirement savings deduction in retirement. Example calculation: $3.84 × (1 + 5%) ÷ 35 × 24% = −$0.0276

The lifetime cost is the sum of these tax amounts over the 35 years that the SSA adds the increased income. The math works even if there are 35 years until retirement, as in the example of a 40 year old, because the cost and benefit both apply incrementally. In the example, which assumes that the changing income level doesn't affect other taxation, the lifetime marginal cost for paying into social security is ($0.1346 − $0.048 − $0.0276) × 35 = $4.00.

You can compare the benefit and cost amounts directly. In the example, causing an extra $1 to be subject to FICA self-employment tax costs you $4.00 overall through your working years but results in a $3.84 overall benefit in your retirement; the cost outweighs the benefit by 4%.

| improve this answer | |
  • One important point is that you won't get anything from Social Security if you don't make contributions over 10 years (40 quarters) of your working life. – Brian Borchers Jan 1 at 20:26
  • @BrianBorchers Regardless of how the business is structured, the number of quarters with contributions won't be affected because a portion of income is always subject to FICA contributions to Social Security. The calculation focuses on just the fraction of income that can be structured be subject to FICA or not. – Edward Brey Jan 1 at 20:36

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.