Defined benefit plans remain the #1 tax deferral strategy. But does a defined benefit plan reduce self-employment tax?
These plans allow for a federal tax deduction and, in most states, a state tax deduction. With average contributions exceeding $100k, the tax savings can add up quickly.
But how do these plans work with self-employment tax? Here’s where is gets a little trickier. Let’s take a look.
Some Background
A defined benefit plan is a type of retirement plan in which an employer promises to pay a specified benefit to employees upon retirement. These plans are funded by the employer and often provide a fixed, predetermined benefit based on factors such as salary and years of service.
Self-employment tax, on the other hand, is a tax that self-employed individuals are required to pay to fund Social Security and Medicare. It’s essentially the self-employed equivalent of the Social Security and Medicare taxes that are withheld from the pay of most employees.
Does a Defined Benefit Plan Reduce Self-Employment Tax?
The number one reason that you have a defined benefit plan is for tax-deferral purposes. However, the self-employment tax works a little differently.
In addition, it’s important to remember that defined benefit plan contributions are not salary referrals. So, they are not reflected on your W-2 form at all.
They are also not a salary gross-up. However, you must check the box on the W-2 that specifies the employee is enrolled in a retirement plan.
These are company-sponsored contributions. So, the tax deductions work mostly like other expenses. But there are a few exemptions to these general rules depending on which tax structure you have.
If you want to understand how these contributions are reflected on your tax return, please click here.
Sole proprietor filing Schedule C
If you are a sole proprietor, any contributions made for you are deducted as an adjustment to income on the 1040 tax return. As a result, it does not reduce self-employment tax.
Please realize that our average client makes $500,000+ a year. So even when they make a large contribution, they are typically still over the Social Security cap. So even though these plans do not directly reduce self-employment tax, you’re usually just talking about saving 2.9% in Medicare tax.
Suppose you have employees for your sole proprietorship. In that case, any contributions made for them can be directly taken on your Schedule C. Because this is recorded on Schedule C and not as an adjustment to income, this will reduce your plan for self-employment taxes.
S-Corporation
About 80% of our clients have S-corporations or C-corporations. These entities are not subject to self-employment taxes. Self-employment taxes are only assessed on your W-2 wage. But any business profit that flows through to the owners is subject to state and federal income tax.
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So, any cash balance plan contributions will be deducted on the S-Corp return, just like any other expense. This amount will then reduce the K-1 income flowing through to the owner. As a result, any cash balance plan contributions will not save on self-employment taxes.
If you have an S corporation, you’re probably aware you must pay yourself a reasonable wage. Because you can get such large contributions from these plans, you may be able to justify a lower salary, which will get you a much higher contribution than you would have with a step or a 401(k) plan.
So, from an indirect approach, they can reduce self-employment taxes. They just don’t directly reduce them. Make sure you discuss reasonable compensation rules with your CPA.
However, the extent to which contributions to a defined benefit plan can reduce self-employment tax depends on various factors, including the individual’s overall income, the contribution limits for the specific retirement plan, and other deductions and credits they may be eligible for.
What is Self-Employment Tax?
Self-employment tax is a tax that individuals who work for themselves are required to pay to fund Social Security and Medicare. It’s essentially the self-employed equivalent of the Social Security and Medicare taxes that are withheld from the pay of most employees.
Self-employment tax consists of two main components:
- Social Security tax: This tax funds the Social Security program, which provides retirement, disability, and survivor benefits to eligible individuals. The Social Security tax rate for self-employed individuals is 12.4% on the first $168,600 of net earnings (this threshold is adjusted annually for inflation), with half of the tax (6.2%) paid by the self-employed individual and the other half paid by their employer (in this case, themselves). If your net earnings exceed the threshold, you won’t owe Social Security tax on the excess amount.
- Medicare tax: This tax funds the Medicare program, which provides health care benefits to eligible individuals aged 65 and older, as well as certain individuals with disabilities. The Medicare tax rate for self-employed individuals is 2.9% of all net earnings, with no income cap. Like with Social Security tax, self-employed individuals are responsible for paying both the employer and employee portions of the Medicare tax.
In addition to the standard Medicare tax rate of 2.9%, individuals with higher incomes may be subject to an additional Medicare tax. This additional tax of 0.9% applies to wages, compensation, and self-employment income that exceeds certain thresholds: $200,000 for single filers, $250,000 for married couples filing jointly, and $125,000 for married individuals filing separately.
Is a Cash Balance or Defined Benefit Plan Right For You?
Self-employed individuals are typically required to report and pay self-employment tax on their income tax return using Schedule SE (Form 1040). It’s important for self-employed individuals to plan for self-employment tax obligations and to set aside funds to cover these taxes throughout the year.
Advantages of a Defined Benefit Plan
Cash balance plans are a type of defined benefit pension plan that are designed to provide retirement income for employees. Here are some potential advantages of cash balance plans:
- Portable: Cash balance plans are portable, which means that employees can take their plan with them if they change jobs. This can be particularly beneficial for employees who may not stay with a single employer for an extended period of time.
- Guaranteed benefits: One of the main advantages of cash balance plans is that they offer guaranteed benefits, which means that employees can be confident that they will receive a predetermined level of income in retirement.
- Potential for higher contributions: Cash balance plans may allow for higher contributions from both the employer and the employee, which can result in a larger retirement nest egg.
- Potential for tax benefits: Contributions to a cash balance plan may be tax-deductible, which can provide tax savings for both the employer and the employee.
- Potential for investment growth: Cash balance plans often include investment options, which can potentially lead to growth in the plan’s assets over time.
It is important to note that cash balance plans may not be suitable for everyone, and it is important to carefully consider the potential advantages and disadvantages of this type of plan before deciding whether it is the right choice for you. It may be helpful to speak with a financial advisor or a retirement specialist to get guidance on the potential benefits of a cash balance plan.
Bottom Line
As you can see, defined benefit plan contributions don’t directly reduce self-employment tax. But if you structure your compensation correctly (with the approval of your CPA), you may be able to justify a lower salary while still getting a substantial contribution.
Self-employment taxes aside, these plans will allow for tremendous tax-deductible contributions. So, they still can make a lot of sense, even without employment tax savings.
It’s important for self-employed individuals to consult with a tax professional to understand how contributions to a defined benefit plan may impact their tax liability and to ensure compliance with tax laws and regulations.
