By Dr. James M. Dahle, WCI Founder
One question I frequently receive by email is whether you as a physician should employ your spouse. One recent emailer is an independent contract emergency physician who also serves as the medical director for several EMS/fire departments. The thinking was that since this unincorporated doctor sends invoices, signs controlled substance forms and scans them in, and mails documents in their medical director/consulting work, perhaps they could employ the stay-at-home wife to take on those day-to-day activities so she could contribute to a Solo 401(k).
The doctor's question: Will I need to officially employ her (i.e., W-9, pay payroll taxes, etc.), or can she take part of the “profit” of my business.
The answer: Yes, you can employ your spouse in this fashion.
Now, let's get to the question they should have asked:
Should I Employ My Spouse?
The answer to that is probably no. Let me explain.
There are generally two reasons why people want to employ their spouses.
#1 Supposed Tax Break
The first reflects a very beginner-level of financial sophistication. It involves a vague idea that there is some sort of a tax break there for doing so. This is not correct. There is no tax break here. Most couples, particularly couples where one spouse is not currently working, file their taxes Married Filing Jointly. Thus, any additional income brought in by the household, earned by either spouse, is taxed at their marginal rate.
In the case of a physician, this is likely quite high. So if you're already in the 32% tax bracket and your spouse earns just $10K, 32% of it is going to the federal government. For this reason, many couples decide not to bother having the second spouse work at all, much less work for the first spouse. However, when you employ your spouse, what you're really doing is lowering your income and raising your spouse's income. From a federal income tax perspective, it's a wash. The $10K you didn't earn was earned by your spouse, but it's all taxed the same.
#2 An Extra Retirement Account
The second reason reflects a more intermediate-level of financial sophistication. It usually comes after someone learns about the benefits of retirement accounts. They realize that if their spouse worked, the spouse could get access to another retirement plan. In this case, both spouses could use the solo 401(k). Now it seems a lot smarter to have that spouse working. Instead of only being able to put $61K into a solo 401(k) [2022], now the couple can put $122K into the solo 401(k), potentially saving an additional $61K*32% = $19,520 off of their tax bill. So what is the problem? Payroll taxes.
The Payroll Tax Problem
Payroll taxes include Social Security and Medicare taxes. The largest piece of that is Social Security tax, which includes 6.2% for the employee and 6.2% for the employer. For an independent contractor, it is essentially a 12.4% tax on the first $147,000 earned by an individual in 2022. So in order to max out a $61K 401(k) contribution, $147,000*12.4% = $18,228 in extra Social Security tax would have to be paid.
While that is less than the $19,520 this couple might save this year on taxes, bear in mind that is a tax-deferral. When they pull that money out of the account in retirement, taxes will have to be paid on it. It is likely to be less than the equivalent of $19,520 in today's money, but it's still going to be enough that paying $18,228 in extra tax now isn't going to make it a winning move. Since the working spouse in this situation has already maxed out his social security tax, transferring income from him to his wife does nothing except increase the Social Security tax that must be paid.
There is a complicating factor, of course. There may be a benefit to paying all that Social Security tax—a larger Social Security benefit down the road. But for many couples in this situation, the non-working spouse may be better off with half of the working spouse's Social Security benefit rather than their own, which would essentially eliminate any benefit whatsoever to paying all that tax.
Remember that Medicare tax really doesn't matter. It will be paid by either spouse since there is no wage limit cap on it.
When Does It Work to Employ Your Spouse?
Now that we've shown that this won't work out very well for the vast majority, let's talk about some situations where it could work.
#1 If Your Spouse Has Already Maxed Out Their Social Security Tax
Instead of having a non-earning spouse, now imagine you have a spouse that is a high earner. Let's say she's a dentist and already maxed out her Social Security tax. Now if she has some additional earned self-employment income, there is no additional Social Security tax due, but she can still use that income to fund her solo 401(k). Bear in mind that you need to make her a partner in your business, not an employee. If she were an employee, you would still be required to collect and pay additional Social Security tax! This may also be a good reason NOT to form this business into an S Corp. If she is an employee dentist and an employee of your S Corp, two sets of Social Security tax would be paid. But if she were self-employed by at least one of the jobs, then there would only be one set paid. Complicated right? But that's the way it works.
It can be just as fun to work with your spouse as to recreate with your spouse
#2 If Your Spouse Takes Less Pay
However, your spouse could max out the employee contribution of a 401(k) on relatively little income. For example, if she were paid $25K, she could put in the entire $19,500 employee contribution (plus a little employer contribution), saving over $6K-$7K in income taxes this year. The cost of the additional Social Security tax would be only $25K*12.4%= $3,100. That might be more worth it. Actually, it's a little less, about $2,600, since half the SS tax is deductible.
#3 If Your Spouse Does a Mega Backdoor Roth IRA
Or you could do what Katie does. She doesn't get paid all that much salary for working for WCI (although she is very well paid in distributions as an owner). But she gets paid enough to put $61K in after-tax contributions into the solo 401(k). As allowed by our customized solo 401(k), she can then do an immediate withdrawal and conversion to her Roth IRA of that money. For the cost of about $6,800 in additional Social Security tax, she can get $61K into a Roth IRA.
Beware the S Corp Plus Employee Combination
Remember if your side business is an S Corp and your spouse is an employee at her main gig, then Social Security taxes will be paid twice. She can apply to get her half of the SS taxes back when taxes are filed (use Form 843) but the employer half never comes back.
Beware the 199A Deduction
An even bigger deduction for many business owners than contributions to retirement accounts is the 199A deduction. If a business is eligible for this pass-thru business deduction, there are two factors to keep in mind:
- Your deduction can be limited if there is not enough salary paid
- Tax-deferred employer contributions to retirement accounts lower the deduction
Keep It Legit If You Employ Your Spouse
Overall, while it is a complex situation, it generally does not make financial success to hire a previously non-working spouse “for the tax deduction” even if it will allow additional retirement contributions. However, if you legitimately need the help, at least hiring your spouse will keep the income in the family, even if the spouse works for free. And of course, when you decide how much to pay a spouse, it must be a reasonable rate for real work done. Paying someone $50K for an hour of bookkeeping a week probably wouldn't fly in an audit. If you do hire a spouse as an employee, you must do all the regular employee kind of things. That means collecting a W-4 and an I-9, having a real employment contract, filing W-2s and W-3s each year as required, and running regular payroll. Adding all that hassle onto a bad financial decision in the first place just makes everything worse.
What do you think? Have you hired your spouse? Why or why not? How did you set it up to maximize the benefits and minimize the downsides? Comment below!
Nicely written. That definitely takes away from the sexiness of the “tax break” by employing your spouse.
I have employed my wife for several years and have no regrets. We made sure she took less pay and maxed out her solo 401k. She also was able to participate in the defined benefit plan I had set up. We still also availed ourselves of the qualified business income deduction as well. To minimize payroll issue I only paid her once a year. We finally decided to stop her employment with me once she obtained another job. It didn’t seem to make sense any longer since she was able to participate in her new employers 401k. As an employee I made sure she had real responsibilities and her work was always documented.
One more little thing that is quite the edge case. If your wife is really close to getting her 40 SSA credits and doesn’t want to job search, there are a couple of nice benefits only possible when both spouses have 40 SSA credits.
Which benefits are you referring to? They’re not springing to my mind immediately and I wonder if I don’t know about them.
Looks like I was mistaken on what I thought was the best benefit. From https://www.healthline.com/health/medicare/medicare-spouse-coverage “You may be able to receive Medicare benefits slightly earlier if you’re at least 62 years old, married to someone who is age 65, and also worked for 40 quarters and you paid Medicare taxes.”
Looking into this further (I hadn’t bothered as I’m a long way away from it happening), this appears to be a misunderstanding by the article’s author, though I’m not 100% on that. The only fun age 62 spousal trick remaining is when the age 65+ spouse hasn’t qualified with 40 SSA credits but the age 62+ spouse has – the older spouse gets part A covered before the younger spouse turns 65.
This usually isn’t a big deal, but I think social security disability is phased out if you haven’t been putting in credits in the last 10 years. We don’t typically worry too much about money being brought in by a non employed spouse, but the spouse usually provides significant non-paid work at home. If the spouse becomes disabled for whatever reason, it is nice to have that disability benefit to cover the non-paid work.
Interesting. First I’ve heard that.
This article is very pertinent for my situation but I have some questions that will hopefully also help others – I am a high earning W2 that already max out my social security taxes. I also max out my 401k for that employer. Now, my wife and I formed a partnership for her CRNA business that I earn some decent income from. I am trying to figure out how much I can contribute to my personal solo 401k for this partnership in addition to my 401k for my W2 employed position. Also, wondering how to do the mega backdoor Roth (as I have never done this before). I set up a Vanguard solo 401k for my wife and just added me as a second person to it but haven’t contributed anything yet. Let’s assume in 2020 I earn $30000 in my portion of the partnership …..how much I can contribute and what my options are for tax-deferred or tax-free retirement account contribution.? Would love some wisdom.
If you’re doing legit work and getting earned income, you can contribute 20% of your net earnings there to a solo 401(k).
The solo 401(k) must allow for after-tax contributions and either in-service withdrawals or in-service conversions. Then you could contribute nearly everything you make up to $57K. But the plan has to be set up to allow it. One of mine has been and one (the Vanguard one) was not. Presumably, your Vanguard cookie-cutter one won’t allow it either, so you’ll be limited to a tax-deferred employer contribution of around $6K with earnings of $30K.
Yes, I too believe this can be a very complicated subject. I think all we can really do is rely on our tax experts and our financial advisors for each individual’s situation.
I work as an independent contractor and have my own PC. It is a C Corp with its on 401(k)/PS plan. I have been in practice for 15 years. I hired my wife 10 years ago for the sole purpose of contributing 100% of her salary to her own 401k under the PC (instructed by the TPA documents). Her yearly salary is the max deferral amount allowed. I believe the tax implications on $19,000 are around $1800-$2000. The trade off is that we get to invest another $19,000 per year and we don’t have to take that money out Of the PC account at a 32% tax rate.
I am fairly new to the WCI investor community, so I realize I’ll have to run the numbers again and do some more research. Any comments are appreciated.
It can make a lot of sense for that first $19.5K. The profit-sharing component? Not so much.
Maybe an unrelated question, but if I’m NOT a 1099/Independent Contractor, but a Business Owner (I own my own practice), so the Solo 401(k) isn’t an option given I have multiple employees.
Employing my wife in my clinic looks different to me than what you’re describing as Independent Contractor Solo 401(k) contributions.
SHOULD I still employ my wife?
Thanks
Probably not unless it saves you from hiring someone else and she wants to work.
I am in a similar situation… except our office has a 401k plan. My wife is on the payroll making just over 20k per year. She contributes 19.5k to our office plan. This has been a winning move so far as I can tell.
I guess that’s probably more of my question…I have a 401(k) plan through my business as well – Wife makes just enough to max her contribution/match. I see that as a benefit, and not sure I see much of a downside…sure payroll taxes, but it sure isn’t more than $19,500 per year!
Employing my wife for THAT benefit seems well worth it, no?
Thanks for all you do!
You’re not comparing to the $19,500. You’re comparing to the benefit of the tax protected growth and any potential arbitrage and the estate planning and asset protection benefits. Hard to quantify them exactly, but it’s not as simple as “the payroll taxes are less than $19,500 so it’s a win.”
I am in a similar situation… except our office has a 401k plan. My wife is on the payroll making just over 20k per year. She contributes 19.5k to our office plan. This has been a wining move so far as I can tell.
What if you put your spouse on salary in your business and the salary is $1 a month. Now you are keeping the money in the family by not hiring another employee and you are not paying those pesky payroll taxes. Your spouse also now has all the company benefits.
I believe she will be subject to the minimum wage established by your state
And there’s that of course.
What benefit does your spouse now have that he or she didn’t before?
You’re still paying Medicare taxes on the money if it coming to you as salary instead of going to your spouse.
I just don’t see much role for a $1 salary.
What benefits does she get as an employee that aren’t received as a spouse?
Not much in retirement contributions on that salary. She might as well work pro bono, no?
Well, that’s all very informative and a bit disappointing. No magic tax potion this time around.
What’s the value in maxing out the Roth contributions (both of you actually) when your tax rate is virtually guaranteed to drop sharply in retirement?
Have you already written the “Should I employ my children?” accompanying piece?
Employing minor children is usually a MUCH better idea. No payroll taxes, probably no income taxes, a deduction to the business, the earned income can go into Roth IRAs etc.
Another advantage is that you can open up a GROUP health plan which is not only cheaper but much better.
An additional advantage is a tax credit for anyone having children who are not school aged yet.
You’re right that a group health plan could potentially be a benefit. I wouldn’t say it is always cheaper and better, but it often is.
Not sure what you’re referring to as a tax credit that comes from employing your spouse. What are you talking about there exactly?
I guess that’s probably more of my question…I have a 401(k) plan through my business as well – Wife makes just enough to max her contribution/match. I see that as a benefit, and not sure I see much of a downside…sure payroll taxes, but it sure isn’t more than $19,500 per year!
Employing my wife for THAT benefit seems well worth it, no?
Thanks for all you do!
Can you give any more details on: #3 If Your Spouse Does a Mega Backdoor Roth IRA? Can one contribute to a 401(k) and perform the Mega Backdoor Roth IRA contribution that you describe in option #3? If so, why wouldn’t everyone in the position to make this contribution, do it? This mechanism is 8 times more beneficial than the typical backdoor Roth IRA!
https://www.whitecoatinvestor.com/the-mega-backdoor-roth-ira/
Yes, you can.
People don’t because they don’t know about it and/or their plan doesn’t allow it.
Another reason to do it is if you have a lot of medical expenses that you otherwise wouldn’t be able to deduct.
You can’t do a Section 105 medical reimbursement plan for yourself, but you could for your only employee. That plan could then cover that employee’s family. The company can then legally reimburse the employee for all of their medical expenses, and it’s deductible in the business.
It’s also easier to write off travel and things if the spouse is an employee, but that all depends on whether or not you think it’s worth the effort of tracking and planning it all.
Just to clarify, this doesn’t work for S-Corps.
Thanks for sharing a great tip.
Not much of an accountant…can someone tell me if what I’m doing is worthwhile/waste of time/brilliant/idiotic?
Me and wife both employed and making above social security limit. Maxing out employer offered plans (401k).
Side gig self employment 1099 nets around 400k
Wife employed in side gig with salary 95K from me
Allows:
wife 56k backdoor roth
wife 95k pre-tax cash balance contribution
me 56k backdoor roth
me 95k pre-tax cash balance contribution
Nothing qualifies for 199A deduction.
The 95k is subject to social security tax, unemployment etc….
Thoughts?
I’m assuming you mean mega backdoor roth.
But yea, I think you could do that if the plans allow it.
Hi, I appreciate all the content you put out. I’m wondering if you can provide additional insight into my situation. I’m a PT with a small practice just myself and my wife, an OT. She sees maybe 1 or 2 patients a week which might bring in $100-$300/wk. The business makes $50-$65K/yr assuming no future growth. We both work enough through traditional W-2 employment to max out our employer-sponsored 401k plans and pay for living expenses. I get healthcare covered through my W-2 traditional employer. As far as our side business profits, we plan to leave 20% of net revenue from the business to help it grow and 80% to be paid at the end of the year. The business is an LLC sole proprietorship, not a partnership or S-corp. I only had my name listed when forming the business. Since we plan to use the profits for a home purchase, it doesn’t matter who the money goes to as long as it’s tax-efficient and legal. Any considerations if we do owners draw to my bank account at the end of the year? I read somewhere that as we are married and file taxes jointly, we both are considered owners even if she isn’t listed in the LLC paperwork. If that is the case, would I also be able to do an owners draw into her bank account or joint accounts? Thanks in advance!