Maximizing deductions can backfire for the self-employed
It is obvious that as a rule, clients want to minimize their tax bills.
“Paying as little as possible is a national pastime. Just look at Donald Trump,” says Tom Fredrickson a CFP financial planner for Fredrickson Financial Planning in New York, an office of Garrett Investment Advisors in New York.
But for the self-employed, maximizing tax deductions isn’t always the right move because doing so can lower the amount of their Social Security benefits.
“In some cases, the strategy can backfire in terms of the Social Security income you’ll receive in return,” Fredrickson says.
Every dollar earned by a self-employed person, after business-related deductions, is subject to a 15.3% tax for Medicare and Social Security, up to earnings of $118,500. The modified earnings total is what is used to calculate Social Security benefits.
“The issue is whether you can do something else with your money to replace Social Security benefits” if you maximize business-related tax deductions, says Anthony Lofaso, a CFP and financial planner at Palm Planning Group in West Palm Beach, Florida.
The maximum Social Security benefit is $2,639 a month.
The question is whether individuals can earn more with the money saved through tax deductions than they would in Social Security benefits.
“I have these discussions with clients all the time,” Lofaso says. “If you’re diligent and put away the tax savings in sound investments, then you can probably compensate and make up the difference.”
To be sure, not everyone is disciplined in this way, Lofaso says.
The approach differs according to age, he says.
The amount of an individual’s Social Security benefits is based on an average of their 35 best earnings years.
For self-employed individuals who are in their 60s, it doesn’t make much difference in Social Security benefits to maximize tax deductions, but it makes a big difference for those in their 50s and younger, Lofaso says.
Fredrickson sees a split impact between the wealthy and non-wealthy.
Because less wealthy people are in a lower tax bracket, the benefit of a tax deduction is less than for someone in a higher tax bracket. Meanwhile, Social Security benefits are more important for the non-wealthy than the wealthy, because many people who aren’t wealthy need those benefits for living expenses.
“As a rule, the lower the income, the lower the benefits of tax deductions and the greater the benefit of Social Security,” Fredrickson says.
This story is part of a 30-30 series on Social Security.