Smart Strategies for Business Owners: How to Minimize Social Security Taxes

As a small business owner, planning for retirement requires more than just saving diligently—it also involves preparing for the tax implications on your Social Security benefits. In many states, Social Security income is subject to both federal and state taxes, which can reduce the amount you actually receive during retirement. This is especially important for business owners who often rely on a mix of Social Security, personal savings, and business income for their retirement plans. To minimize Social Security taxes and maximize your retirement income, it’s crucial to implement proactive financial strategies now, such as optimizing retirement savings, managing business income, and diversifying your investments. As always, consult with your accountant or tax attorney for professional guidance.

Here are some steps you can take to prepare for these tax challenges and secure a more comfortable retirement.

1. Maximize Contributions to Your SEP IRA

Since you’re already contributing to a SEP IRA, continuing to maximize these contributions is key. The SEP IRA allows you to reduce your taxable income now, which can also lower your Social Security tax burden in retirement, depending on your overall income. Since you’re expecting Social Security to be about half of your income, maximizing other retirement savings can help keep your overall income in a lower tax bracket when you retire.

Strategy:

• Aim to contribute the maximum amount allowed annually to your SEP IRA. For 2024, this is up to 25% of your compensation or $69,000, whichever is lower.
• You may also consider setting up a Roth IRA in addition to your SEP IRA if you qualify. While contributions to a Roth IRA are made with after-tax dollars, withdrawals are tax-free in retirement. This will diversify your tax exposure and help reduce taxable income later on.

2. Plan for a Taxable Social Security Benefit

If you’ll be living in a state that taxes Social Security and expect to earn at least $25,000 before age 70, you’ll likely have a portion of your Social Security benefits taxed. The IRS taxes up to 85% of Social Security benefits if your income exceeds certain thresholds ($34,000 for single filers; 44,000 for married couples filing jointly). Depending on your income, this can be a significant tax hit.

Strategy:

• Delay Social Security: If possible, delay taking Social Security benefits until you reach age 70 to maximize your monthly payments. Higher benefits can help offset the tax burden.
• Income Splitting: Consider ways to manage income in retirement to avoid spiking into a higher tax bracket. You may want to space out withdrawals from your SEP IRA or other taxable accounts to avoid higher marginal tax rates.

3. Reevaluate Your Salary Structure

Since you’re drawing a salary from your business, this income affects both your current tax situation and your Social Security contributions. Higher salaries now mean higher Social Security benefits in retirement, but they also increase your taxable income in retirement.

Strategy:

• Consider adjusting salary vs. distributions: If appropriate, balance your salary with business distributions, which may have different tax implications. Lowering your salary could reduce current taxable income while still allowing you to save through other means like your SEP IRA.

4. Diversify Retirement Income Sources

You expect Social Security to make up half of your retirement income, which leaves the other half coming from other sources. Diversifying your income across tax-advantaged and taxable accounts can help lower the overall tax burden.

Strategy:

• Roth IRA/Backdoor Roth: If you’re over the income limits for a Roth IRA, you can still make contributions via a Backdoor Roth. This will give you a source of tax-free income in retirement, which won’t affect the taxable portion of your Social Security benefits. This tax diversification can help reduce the overall impact of Social Security taxes.
• Non-Qualified Investment Accounts: Consider investing in brokerage accounts where only capital gains and dividends are taxed. Long-term capital gains are typically taxed at a lower rate, so these accounts can supplement your income without raising your tax bracket as much as SEP IRA withdrawals might.

5. Tax-Efficient Withdrawals During Retirement

Once you retire, managing how you draw from various retirement accounts can significantly impact how much Social Security is taxed.

Strategy:

• Withdraw from taxable accounts first (like brokerage accounts) to take advantage of lower long-term capital gains rates and keep your income below the thresholds where Social Security becomes highly taxable.
• Use Roth withdrawals to supplement your income without increasing taxable income.
• Save SEP IRA withdrawals for later years when you may be in a lower tax bracket.

6. Consider Relocating for Tax Purposes

If you’re in a state that taxes Social Security, you might want to evaluate whether relocating to a state that does not tax Social Security benefits is a viable option for you. States like Florida, Texas, and Nevada have no state income tax, which could lead to significant savings in retirement.

Strategy:

• While this might not be a step you can take immediately, it’s worth considering as you plan for retirement, especially if the tax savings can outweigh the cost of relocating.

Summary of Actions:

• Maximize contributions to your SEP IRA and consider adding a Roth IRA for tax-free withdrawals.
• Delay Social Security if possible, and manage your retirement income to minimize taxable Social Security benefits.
• Adjust salary vs. distributions from your business to optimize tax efficiency.
• Diversify income through tax-advantaged and taxable accounts to spread the tax burden.
• Consider relocation to a tax-friendly state as part of your long-term retirement strategy.

These steps can help you reduce the overall tax burden on your Social Security and retirement income, allowing you to keep more of what you’ve earned.