What is it?
As a business owner, you may save Social Security taxes (self-employment taxes) by postponing or accelerating income so that your earnings are bunched in alternate years. This strategy works if you are self-employed and your annual earnings are at or near the maximum earnings base because your earnings count for Social Security purposes in the year they're received, not in the year they're earned. Since earnings over the maximum earnings base are taxed at a lower rate than earnings at or under the maximum earnings base, you can save payroll taxes if you bunch your earnings so that they exceed the maximum earnings base in alternate years.
How does it work?
Understanding self-employment taxes
If you're self-employed, you pay a self-employment tax equal to 15.3 percent of your earnings to finance Social Security. Of this tax, 12.4 percent goes to OASDI (Old-Age and Survivor's Insurance Trust Fund and Federal Disability Trust Fund) to finance your retirement, survivor's, and disability benefits, while 2.9 percent of this tax goes to HI (Federal Hospital Insurance Trust Fund) to finance your Medicare benefits.
Understanding the maximum earnings base
The maximum earnings base is the maximum amount of earnings that are subject to the OASDI tax. This amount is also the maximum amount of earnings credited to your Social Security record. The maximum earnings base (in 2023, $160,200) is determined annually.
How the maximum earnings base affects your self-employment tax
You don't have to pay the OASDI tax on any earnings you have in excess of the maximum earnings base. However, you do have to pay the HI tax on earnings in excess of the maximum earnings base.
Caution: You may also owe an additional Medicare payroll tax of 0.9% if you have high earnings. If you're self-employed, this additional tax applies to net self-employment income that exceeds a certain threshold amount for your filing status.
How to do it
Estimate your earnings
Estimate your earnings for the current tax year. If you are able, project your earnings for the next tax year as well. Is it likely that your earnings will approach or exceed the maximum earnings base in either tax year? If the answer is no, bunching your earnings isn't likely to benefit you in terms of Social Security taxes. If it appears that your earnings may reach or exceed the maximum earnings base in one year but not the other, however, it may make sense to try to shift earnings into the tax year in which you'll exceed the maximum earnings base.
Accelerate your earnings
Your earnings from self-employment count for Social Security purposes in the year they're received rather than in the year they're actually earned. If you believe that your earnings will exceed the maximum earnings base in the current tax year but not the following tax year, you may want to consider accelerating earnings into the current year. Why? Any self-employment earnings you have that exceed the maximum earnings base in the current year will be subject to the HI portion of the self-employment tax, but not the OASDI portion. Since your earnings in the following tax year will likely not exceed the maximum earnings base, and thus will be subject to both the HI portion and the OASDI portion of the self-employment tax, you can benefit from accelerating your earnings into the current year.
Postpone your earnings
If you believe that your earnings will reach or exceed the maximum earnings base in the following tax year but not the current tax year, you may want to consider postponing earnings into the following year. Again, by doing so you could avoid the OASDI portion of the self-employment tax on the earnings deferred.
Consider your overall tax situation
Bunching your earnings from self-employment may help you save Social Security taxes, but you should consider the overall tax implications. For example, if your earnings in one year are high enough, you may be subject to the additional Medicare payroll tax and the Medicare investment income surtax, or even be pushed into a higher income tax bracket, among other things. Consult a tax professional for help with your individual tax situation.
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This article was prepared by Broadridge.