By Adam Cmejla, CFP®
March 29, 2023
One of the benefits of owning your practice is the additional control over the income that the practice generates and how you, the owner, dictate which line of your personal tax return that income lands on. Which line it’s on influences not only how much, but which kind, of tax you will pay.
Paying Yourself a “Fair Wage”
Regardless of whether your practice files a 1065 (Partnership) or 1120S (S-corporation) tax return, the IRS requires practice owners to pay themselves a “fair wage” via either “guaranteed payments” (Partnerships) or W-2 income (S-corporations). From a work point of view, this type of compensation is typically associated with the work that is done by the owner IN the practice clinically. While there is no specific formula or guidance on how much this amount should be, the IRS uses the term “reasonable compensation” in their guidance. One way to think about it is to ask yourself the “replacement cost” question: “How much would I have to pay an associate OD to work my clinic schedule?”
From a tax perspective, the reason the IRS requires this is to ensure that business owners pay into two of the largest and longest-standing social programs in our country’s history: Social Security and Medicare. The specifics of the rest of this article will be focused around Social Security, because it’s really the only tax that we pay where we can tie a direct “benefit” in the future in exchange for the taxes paid throughout our working years.
Social Security and Medicare taxes are commonly called “payroll taxes” because only earned income is subjected to these taxes. The combined tax rate for these two types of taxes is 15.3 percent on the first $160,200 (in 2023): 7.65 percent is paid by the employee and 7.65 percent is paid by the employer. Of this total tax, Social Security is 6.2 percent for both employer and employee, bringing the total to 12.4 percent, with the other 2.9 percent being the collective Medicare tax paid 50/50 by employee and employer.
How Much Should I Pay Myself for Greatest Long-Term Gain?
With this information, we can see that how much a practice owner chooses to pay themselves can have a material impact on how much of a total tax bill they pay. With that said, let me now state the obvious: I have yet to meet someone who enjoys paying taxes, and this includes optometric private practice owners. However, I also mentioned that this is the one tax that we can calculate our “return on investment” on the tax paid while working and the future benefit we’re entitled to when we retire.
So, the objective becomes to determine if paying a high salary, and thus, more in Social Security taxes yields to a significantly higher Social Security benefit or whether we’d be better off paying ourselves as low of a “reasonable salary” as possible and then investing what we otherwise would have paid in Social Security taxes into an investment account, essentially “self-insuring” for the future benefit that Social Security would pay.
Our test subject in this experiment is going to be an optometric practice owner who is 35 years old. This practice owner just purchased the practice from another OD and they are now deciding how much they should pay themselves in W-2 wages. Let’s also assume that this practice owner doesn’t plan on taking Social Security until their full retirement age, which for them would be at age 67.
Using the simplified calculator on the Social Security website, three different “bands” of income at age 35, and then nominal (3 percent) raises each year, were inputted. All assumptions made by the calculator were kept the same to isolate our control variable.
The following numbers are the output on future benefits that our hypothetical OD would receive. I’ve also shared the difference in monthly income between the highest monthly benefit and the other lower benefits received. Lastly, I calculated what value of a portfolio would be needed to produce the same amount of monthly, pretax income based on a 4 percent distribution rate from the portfolio.
At first glance, it can seem that there’s a sizable difference in future Social Security benefits between the $80,000 and $160,200 annual salary, so that our OD might want to pay themselves a higher salary. But remember that as a practice owner, you pay both the employer and employee portion of Social Security. The higher benefit doesn’t come without its cost.
Therefore, to calculate the total “cost” of a higher Social Security benefit at retirement (the difference between an $80,000 salary and a $160,200 salary), we need to take the difference ($80,200) and multiply it by 12.4 percent (total Social Security tax paid). The total tax paid on the difference between $80,000 and $160,200 is $9,945. Now it’s a simple time value of money calculation to determine what the $9,945 could grow to if that amount was invested annually into a portfolio returning 7 percent over the 32-year period (age 35 to 67).
The value is significant: $1,096,120.
Needless to say, the size of the portfolio is more than enough to make up for the difference illustrated in the fourth column in the table above. Said differently, using the same distribution rate of 4 percent, this portfolio could provide roughly $43,800 of annual income, or $3,600/month—over 3x the value of what Social Security would provide!
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The Fine Print
Before you immediately head over and change your wages in your payroll software, let’s discuss the details and caveats around this strategy. First and most importantly, you must be committed to investing the tax savings into a portfolio, essentially “self-insuring” for your future retirement income. Spending that money instead of saving it will not only ensure a lower Social Security retirement benefit, but it may also raise your future cost of living in retirement, since spending that money could create and lock in a higher monthly retirement income that would be required to sustain your lifestyle.
From a tax and compliance point of view, you are also opening yourself up to a higher chance of an audit since significantly underpaying yourself is one of the easiest ways to flag your return. This comes back to the whole “reasonable compensation” calculation. While there is no specific table to dictate how much you should pay yourself to keep out of the audit cross-hairs, the replacement cost is a good way to start thinking about those numbers.
You must also be aware of the importance of time in this calculation. Notice that the hypothetical example I used was that of a practice owner who was 35, with decades of time in front of them as a practice owner. The longer the timeline, the more the power of compounding interest works in your favor, allowing for that investment portfolio to grow.
For an OD reading this in their mid-to-late fifties, your better “investment” might well be to pay higher wages to accumulate a higher Social Security benefit if for no other reason than not having the time for the Social Security tax savings to compound. This is where doing your homework and running the numbers is prudent and paramount.
In addition, the hypothetical investment portfolio illustrated previously does not have the word “guarantee” in front of it. While we can all debate the political merits of the word “guarantee” and Social Security, as it stands right now, it’s one of the few situations in which we can use the words guaranteed income when talking about financial planning strategies.
Lastly, Social Security could always change its benefit calculations–for better or for worse. However, we plan with what we know and the rules as they stand today and adjust as needed going forward.
As a practice owner, you have great control over the patient experience you provide and the way in which you run your practice. Don’t overlook the control you have over your income, how it shows up in your personal life and the effective tax rate you pay on those dollars. The business of optometry should help you live your best life, on purpose. Be intentional about the way you manage your cash flow. The more of it you can control and keep, the better chance you have of achieving financial independence sooner rather than later.
Adam Cmejla, CFP® is a CERTIFIED FINANCIAL PLANNERTM Practitioner and Founder of Integrated Planning & Wealth Management, LLC, an independent financial planning & investment management firm focused on working with optometrists to help them reach their full potential and achieve clarity and confidence in all aspects of life. For a number of free resources, visit https://integratedpwm.com and check out the “20/20 Money Podcast” to get more tips on making educated and informed financial and business decisions.