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.
- 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.
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.
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
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%.
