Someone asked me: “my accountant suggested that I pay my wife as an independent contractor to save taxes. Is this a good idea?” Yet another litmus test to see if your accountant or financial advisor knows what they’re talking about.
Long story made short: usually if your practice has a 401K, pay your spouse as an employee $21,000; if your practice has a simple IRA, $14,532; if a DB plan it depends; SEP IRA or no practice retirement plan: zero.
Line of reasoning: if you don’t have a retirement plan, it’s either a wash or you could actually LOSE money by paying a spouse. Why? Any deduction your business from paying your spouse- is taxable to your spouse, at the EXACT same tax rate, unless you’re married filing seperately. So if you’re filing jointly, unless you have a retirement plan, it’s a wash, perhaps even a loss.
You wouldn’t want to file married filing separately just for this as more of your income would be taxed at higher brackets faster, negating any money your spouse would save being taxed at lower brackets.
Why could it be a loss? Because of FICA (social security) and medicare taxes. If you’re a sole proprietor, you pay FICA and medicare taxes of 15.2% on the first $142,800 for 2021. Most of us will be earning over that. So assuming your wage is over $142K, any income you shift over to your spouse is subject to an additional 15.2% FICA/ medicare tax on your spouse.
If your business has to pay workmans comp and unemployment insurance tax on your spouse salary, it could make even less sense to pay your spouse. Admittedly workmans comp will be very little, but if your practice has many unemployment claims and a high tax rate this could add up.
If your spouse earned over $142,800 from another job, then when your company issues wages, you’re still required to withhold the 7.6% EMPLOYER portion of the tax. So by shifting income from you to your spouse you’re losing between 7.6-15.2% percent.
What about giving your spouse some earnings for a traditional/ backdoor Roth IRA? You can do a spousal IRA from your earnings. No need to shift income to your spouse for this.
What about trying to maximize social security? First of all, your spouse will get spousal benefits based off your earnings, up to 50%. Secondly, social security is a regressive tax. You definitely don’t want to pay your spouse $142,000 to max it out. That’s a extra $22,000 in FICA taxes every year for minimal future benefits. You’d be better off investing the $22,000 now in a post tax account and paying capital gains.
If you even want to play this game, to make sure your spouse is eligible for social security disability, then you need four base credits every year. Each base credit for 2020 is $1410 of earnings. So pay your spouse $5640, resulting in a extra $880 of FICA taxes, if you really want earnings records for social security disability for your spouse.
Now, what if you have a retirement plan? The reason why you should pay your spouse $21,000 for 401K or $14,500 for a simple is because half of the FICA/ medicare tax is taken out. So these numbers are about 107% of the the $19,500 401k/ $13,500 Simple IRA employee contribution limit (and your company would also give an employer contribution).
Say you lived in CA and was at the 35% federal/ 11% state marginal tax bracket. This is 46%. If your spouse got $21,000 income it would be taxed at only 15.6% (the fica and medicare rates added). This is a 30.7% arbitrage- $6447, and the money would be in a tax advantaged, asset protected account, although it would be taxed again on withdrawal, albeit at lower rates unless your income was over about $200,000 in retirement.
If you lived in Nevada (no state tax) and earned under $326,000 then you’re only in the 24% bracket (19.6% with pass through deduction) it’s barely any tax arbitrage over the 15.6% fica tax you pay. Because you will probably be taxed at more than 4% at withdrawal at retirement this may not be worth it, unless you forecast your income will be under the standard deduction at retirement and taxed at the zero percent rate.
You usually don’t want to max out your spouse’s 401K. This is because the employer match is based on only 25% of wages, whereas you’re getting hit with the FICA/ medicare tax on almost all of it.
You’d need about $180,000 in spouse wages to hit the $57,000 maximum 401k deferral limit. Paying $180,000 in wages vs $21,000 in wages means paying a extra $21,000 of FICA/ medicare taxes- just to defer another $37,000 at a 57% tax rate, which will be taxed later on withdrawal. Doesn’t sound like a good deal to me. This is also why if you have a SEP IRA the spouse pay should be zero- there’s no employee contribution, just a 25% employer contribution.
If you pay your spouse, they must to bona fide work at market rates. If the IRS audits you, the test used is would you hire someone else off the street at the same rate for the same amount of hours to do the same job?
Hiring your kids is a much bigger tax break. All of their earnings will likely get eaten up by the standard deduction so taxed at 0% rate (if not 10%), and if they put the money in a Roth IRA it will compound for many years. Again they have to do bona fide work as described above, the IRS guidelines are over age 7.
Finally, the person who asked me the above said their accountant recommended hiring spouse as an independent contractor. This is a terrible idea, because then the spouse couldn’t participate in the practice retirement plan, if your practice has employees.
The spouse wouldn’t be allowed to do a solo 401K plan with the independent contractor earnings because of IRS rules of controlled groups. If your spouse owns the business, it’s also considered yours in the eyes of the IRS, and you need to apply the same retirement plan across ALL businesses you and your spouse own- precluding a solo 401K.
If you have employees, there’s NO tax advantage to having your spouse as an IC (unless you’re married filing separately which would cause you to pay more for your own taxes anyway), and it’ll probably cost you 15.6% more because of FICA/ medicare taxes.
If you are a single doctor with NO employees (say ER or anesthesia), AND your spouse earns over the FICA limit, AND you can pay them as a 1099 so there’s no need to withhold half of FICA taxes, AND you can find them bona fide work, then it makes sense to pay them enough to max out their 401k.
The person who sent me this question is on their third accountant. I have a feeling they’ll soon be on their fourth accountant….
Note: virtual AAO is available until February 15, 2021. Search the program if you’d like to listen to my two courses, How and why to start a solo practice in 2020, and Personal finance for ophthalmologists.