I don’t hate people who make money. We live in a capitalist society and if someone wants to work hard for many years, come up with some new useful idea or invention or a clever way to make money legally, hey, I think they deserve it. However, during my second year working at a bank, I noticed a curious bump in my bi-weekly pay after I received my bonus that couldn’t be explained by may pay increase.
Living in New York City, we pay a lot of taxes. There are Federal taxes, state taxes and yes here, there are city taxes. So I had always closely monitored my total take home after taxes. The total tax rate that you pay after adding all those taxes up is called your marginal tax rate. In order to budget my money and make sure I had extra money every paycheck to invest, I would know exactly how much I received every other week after taxes (and I suggest you do too). But after I received my bonus (I like to call it what it is, a commission, but I will tackle that in another article) I noticed that for some reason my tax rate went down a few percentage points and I was taking home more money. I decided to do a little research online and discovered that I had exceeded what the government decided was enough for me to just stop paying my social security tax ( or as they call it contribution this is how they get out of calling it what it really is, a tax) for that year all together.
Really? Yup, there is what’s called the maximum taxable earnings for social security. It goes up slowly every year based off of inflation but once you exceed that magic number, your taxes go down by 6.2%.
In fact, you can avoid this tax in other ways than just making over 118’500. Social security only taxes wages, so those making all of their income from investments don’t pay this tax, they just pay their federal, state and local taxes and they are good. Who would these people be? It’s not just the super-rich that have investments so huge they can live off the dividends. For example I own a few houses, I lease these houses above what their monthly costs are, however as my accountant explained to me, this income is not subjected to social security tax because it is not a wage that I am receiving.
Besides being grossly unfair, did you know that if they were to take this limit on social security taxes off, they could essentially fund all the future shortfalls that they will have in social security you may have heard of in the presidential debates and 24 hour news channels? Check it out here (your tax dollars have actually paid for the info to let you know this, the irony).
But I am not here to talk politics; I am here to help you use knowledge of the system to beat it. So here are the ways to avoid the social security tax:
Religious Exemption – Yes the government will give you a pass on paying this tax if you actually renounce all your future social security benefits based on religious grounds. However, the religious group must have existed as of the end of 1950 and must have continuously provided its dependent members with a reasonable standard of living since that time, probably not an option for most of us.
Temporary Student Exemption – Students working for the same school they’re enrolled in may be temporarily exempt. Your employment must be dependent on your enrollment, so be careful here, I would consult with an accountant.
Foreign Government Employees – Employees of foreign governments are generally exempt from paying Social Security taxes on income paid to them as a result of their official responsibilities. This is kind of like working as a diplomat. However the American tax man will get you, if you are a US citizen your income is taxed all over the world even if you work for a foreign government, so no help for you US citizens here.
Start a Company – Now here is where it can be a bit tricky, in consultation with my accountant if you have an s-corporation or an LLC, they recommend paying yourself a salary that is about 2/3’s of your projected gross personal income from the company. Yes you will have to pay social security on the 2/3’s you get as wage income but you do get some savings for the 1/3 that is not wages. This is of course after you have taken advantage of all those business deductions you hopefully have made to shield your taxable income.
Dividends, Interest and Capital Gains – The dream of every extreme saver. The interest and dividends that you receive on your investments are either taxed as regular income (but not as a wage and hence no social security tax) or at long term investment tax rate. This latter tax applies to capital gains (in the case of a stock, the increase in price from what you paid for it originally and held onto for over a year) and qualified dividends (mostly the dividends from your boring big company stocks). Even after Obama revised the long term investment tax it still only went up to 20% for most of us.
Real Estate – One of my favorite tax shields, real estate gives you a number of opportunities to avoid social security tax on you income from this asset class. Say I were renting a house I owned for $5000 a month and my costs, including the mortgage, taxes and insurance were only $2500 a month. Well right off the bat I get to deduct about $2100 (a $400 portion of this is the principal on my mortgage) then we start adding the deductions. Is this place far away? Deduct the cost of getting there. Did you have to make any improvements? Deduct those too. In addition, you start getting deductions after you start renting the home for depreciation. The depreciation on the home I own comes out to about 3% of its purchase price over the course of 30 years. In my case that comes to approximately $800 per month. Add up these deductions and soon you will find yourself paying tax on just a portion of that $2500 income or maybe even none at all. Landlords have been using these deductions for a long time and you extreme savers out there who own real estate probably definitely know about the advantages of these deductions.
These are all ways to avoid social security contributions for earnings below the social security income cap. If you are an aggressive saver and investor and still can manage to keep a high paying day job, this is where things can start to get unfair because you can make the investments mentioned above in stocks, bonds and real estate and not have to even worry about social security for any of them because you have already paid your share through your wages. Unfortunately for the little guy the people who pay little or no social security who are rich wield a lot of influence on the government so (Democrat and Republican) they have ensured that that cap does not get taken off and they retain their exemption on their investments for the future.
But Like Everything, There Is a Drawback
However there is a very good reason that the social security tax is capped, and this is because the benefits you receive at retirement are calculated based on your earnings over 35 years and the cap on taxing wages allows the government to set a limit on your payouts at retirement. In other words, even if you made 1 million every year for 35 years, the government looks at it like you earned $118,500 annually and makes its social security payments to you based on that. In essence, the government made a deal with the rich, we will cap the amount you are taxed if you agree to cap the amount you get at retirement.
The calculations are not very difficult for what you can get at retirement and the Social Security Administration even provides various free calculators if you provide them with some assumptions for estimating what you will receive from social security at retirement here.
I used the simple calculator to calculate what my monthly payout would be at retirement if I were to earn the maximum allowed every year of $118’500. The payout below is in today’s dollars.
So the drawback that people don’t tell you when they talk about retiring early on many of the extreme saver websites you might read is that you give up a large portion of your social security payments. Just to see what that might be like, let’s assume in the calculator I just showed you above that that person made $100,000 a year, saved a ton of money, made some good investments that ensured that they could live off the money and avoid paying into social security for the rest of their life. At 65 that person will still get something but it will look more like this:
So in this case, this person is giving up about half the social security they will receive per month at retirement in order to retire early. For someone able to retire early and who is confident they have made the right investments to last them well into their golden years or for the person who has planned for retirement not accounting for social security, they may be willing to give this up. I am sure that knowing this, some of you may think twice before throwing guaranteed benefits from the US government out the window. At the end of the day the decision is yours and whatever you choose has costs and benefits.
Is There Any Other Way?
Yes there is. There was a lot of debate after Bush was reelected in 2004 about privatizing social security. There was a huge uproar, especially from those close to retirement about not touching the plan as it is because they were depending on those payouts and they preferred a government guaranteed payout over something private and subject to market conditions. The plan never materialized and the issue was dropped shortly after. However there are places in the world that have taken a revolutionary and unique approach to retirement planning for their entire populations that the US could learn from. My favorite example is Chile.
In Chile what they have done since 1981 is automatically enroll all workers into a retirement fund administered by an investment manager hired by the government. Each employee pays 10% of their wages into the retirement fund every year that they work. The maximum you can pay in per month is capped at about US $280 currently. Self-employed individuals may contribute voluntarily, and salaried workers can also enhance their pension through additional voluntary contributions. The government guarantees you a minimum pension if you contribute to the system for 20 years, if the pension fund has a shortfall in payments or goes bankrupt the government will pay in the difference so that all get at least the minimum pension benefit. Employees have the option to choose between funds that compete for their business and if they don’t want to bother with that the government will automatically enroll you in one. In addition, if you exceed certain thresholds, you can retire early, take out excess cash in a lump sum and none of this is taxed until you start to receive it.
If we had a system like this in the US it would make retirement planning much more exciting and dynamic as well as guaranteeing people who at least try to work can have a stable retirement even if they do very little planning. You can read an op ed on the plan from the former minister of Labor and Social Security here.
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