By Dr. Jim Dahle, WCI FounderI hear plenty of doctors talk about or ask about hiring their spouse. The idea out there is that there is some huge tax break available by hiring your spouse to do some sort of trivial work for your business (schedule your shifts as a hospitalist?). Today, I want to disabuse you of that notion.
What Are the Benefits of Hiring Your Spouse?
It's not like there aren't good reasons to hire your spouse. Let's go through those first.
#1 You Need the Help
Sometimes, your business just gets overwhelmed. You need help. Hiring and training a new staff member takes time. Your spouse is smart and hard-working and cares more about the success of your business than anybody you could possibly hire. Fine. Hire your spouse. While you'll lose the benefits of whatever your spouse was doing before they came to work for you, you'll gain back whatever you would have paid someone else to do that work your spouse is now doing. Honestly, though, you ought to give serious consideration to just having them volunteer their time in the business. You'll probably come out ahead.
#2 Your Spouse Can Increase Their Social Security Benefit
Maybe your spouse doesn't yet have their 40 quarters to qualify for their own Social Security benefit. Or perhaps they're still way below the first bend point in Social Security and having some more Social Security earnings could dramatically increase their eventual benefit. That might be a reason for your formerly stay-at-home spouse to do some paid work. That doesn't mean they have to work for you, of course, but see #1 above. If you need help and they're the best person for the job (or they work cheaper than anyone else), go for it.
#3 You Can Make a 401(k) Contribution for Them
If your spouse has earned income and your business offers a 401(k), they can put some (or sometimes just about all) of their earned income into that 401(k), providing an additional upfront tax break in the tax-deferred subaccount and the usual benefits of retirement accounts no matter what subaccount you use.
More information here:
Can I Hire My Spouse as an Employee?
Why Hiring Your Spouse Is Dumb
Let's get to the main point of this post. For most doctors, hiring your spouse is dumb. Downright stupid. The benefits simply do not outweigh the costs. What are the costs? To start with, there are the costs and hassles of employment. You've got to fill out an I-9, W-2, W-3, and W-4. Employment contracts. Time cards. Your spouse is a legitimate employee, and you need to treat them as such.
However, the main cost is the additional payroll taxes. Let's say you make $400,000 a year. For some reason, you decide you want to hire your spouse and pay them $100,000 of that $400,000 a year. The Social Security Wage Limit (above which you do not pay Social Security tax) is $176,100 for 2025. That means that when you were making $400,000, you only paid Social Security taxes (12.4% for the self-employed, although half of that is a business deduction) on the first $176,100 of that $400,000. However, if you pay your spouse $100,000, you're not just paying Social Security taxes on $176,100; now, you're paying it on $276,100 of that $400,000.
12.4% * $100,000 = $12,400.
That's a lot of money. Same household income. More tax. See the problem? It can be even worse if you've set yourself up as an S Corp. Let's say you're an S Corp and you're paying yourself a salary of $200,000. Now, you only pay Medicare tax (2.9% for the self-employed although half of that is deductible as a business expense) on the first $200,000. If you hire your spouse for $100,000, you're not only paying an extra $12,400 in Social Security taxes, but you're also paying an extra $2,900 ($15,300 total) in Medicare tax.
The worst part about paying all of these extra taxes is that your spouse may not be getting much, if any, benefit for paying them. Your spouse can qualify for full Medicare benefits without ever working, simply based on your work record. And if your spouse's Social Security benefit is less than 1/2 of yours (very common in one-doctor households, particularly when there has been a stay-at-home spouse for many years), there's no additional benefit to paying all of those additional Social Security taxes. Your spouse will simply opt to receive 1/2 of your benefit instead of their own. Even if you die young, your spouse will simply get your full benefit rather than their own.
But what about the benefits of that retirement account? Yes, retirement accounts are great places to invest. But with reasonable assumptions, the benefits can be calculated, and they have a limit. Let's say you pay your 48-year-old spouse $100,000. How much can they put into the 401(k)? In 2025, they can put in their $23,500 employee benefit. Then, they can put in close to another $20,000 as an employer benefit. This assumes that your spouse is your only employee and you're using a solo 401(k). If you have other employees and an ERISA 401(k), that's probably going to be a lower amount.
At best, you're going to contribute something like $43,000 in tax-deferred dollars. Your immediate tax break on that $43,000 (you're probably in the 24% tax bracket) is going to be $10,320. That's less than the $12,400-$15,300 you're paying in additional payroll taxes. You know what's worse, though? You're only deferring the tax on that $43,000, not eliminating it. But the additional payroll taxes? They're gone forever. So, maybe you get an arbitrage on that tax rate. Maybe it goes in saving 24%, but it comes out at an average of 15%. Your real tax savings there is $43,000 * (24%-15%) = $3,870. That's not even close to $12,400.
Yes, there is some benefit in the tax-protected growth of a 401(k). Yes, there is some benefit in the asset protection and estate planning features of the 401(k). But it's not enough to make up for paying an extra $8,000+ in payroll taxes you didn't have to pay and which won't be providing much, if any, benefit to you. Even if you get a customized solo 401(k) and do the Mega Backdoor Roth IRA process for your spouse (and thus get the total contribution up to $70,000), it still isn't going to pencil out for most physician families.
Can I Hire My Spouse as a Contractor?
But what if you hire your spouse as an independent contractor? Does that somehow change the equation? Not really. Somebody still has to pay those payroll taxes. Does it really matter to your family if your business pays them or your spouse's new business? Same cost either way. It doesn't really help you avoid the ERISA-related issues with your employees either (i.e. have to include the spouse's 401(k) contributions when doing non-discrimination testing) since the businesses will be considered “a controlled group” unless they meet all of these exceptions:
- Each spouse owns nothing in the other’s company;
- Neither spouse is a director, employee, or management participant in the other’s company;
- The companies do not derive more than half of their income from royalties, rents, dividends, interest, and annuities; and
- There is no limitation or restriction on either spouse’s ability to sell his or her company that runs in favor of the other spouse or their minor children.
You also, of course, have the usual issue of the IRS not looking fondly at businesses that pretend their employees are independent contractors.
The bottom line is that yes, you can hire your spouse as an independent contractor, but no, it's probably not the brilliant tax move that you thought it was.
More information here:
Why I Gave My Business Away; Pros and Cons of Adding Spouse to LLC
Why Hiring Your (Minor) Kids Still Makes Sense
Just because hiring your spouse is probably dumb, hiring your kids is not. The main issue here is making sure your kids are actually doing legitimate work and paying them a legitimate wage to do it. You can't pay them $400 an hour to feed charts into a shredder or do a crummy job sweeping the floor. You still have to do all that paperwork (I-9, W-2, W-3, W-4, employment contract, time card), but the tax benefits are awesome.
If your business is a sole proprietorship or partnership (or an LLC taxed as a sole proprietorship or partnership) and the only owners are their parent(s), minor children don't pay payroll taxes. Plus, they almost surely won't have enough earned income to owe income taxes ($15,000 in 2025). But since it is earned income, it can all go into a Roth IRA and never be taxed again. That's triple tax-free and pretty awesome. Heck, it might even be better than an HSA (depending on whether your HSA is funded via employer withholding). Maybe we should call it quadruple tax-free.
The bottom line is that if you're looking for a big tax break, hire your kids instead of your spouse.
What do you think? Have you hired your spouse? Why or why not? How did it pencil out for you?
Interesting for me to see just how different it is in the US for this aspect. For the small minority of your readers that are Canadian, it is a different ballgame. We can opt-out of employment insurance as self-employed with non-arms-length employees. Our CPP benefit is directly proportional to what we contribute via payroll. We are taxed as individuals rather than a household. Personal income tax here is pretty progressive (~54% by around $175K US income). So, shifting income from a high-income to low-income spouse often makes a massive difference for us. Either as salary, or potentially dividends if incorporated and their contribution to the business is substantial enough.
-LD
Thanks for sharing. I’m always getting requests for more Canada specific info, but just don’t know as much as I’d like and don’t get nearly as many guest posts as we’d like to run on the topic.
Eldest kid’s Roth IRA started with the $5K I paid her for babysitting younger. No payroll taxes, earned income, gave her sizable allowance so she could Roth it all. (Then after those few years no more employment income for years!) Youngest didn’t have any such job, ah well. And the experience didn’t stop eldest from eventually reproducing- we used to joke that we had (teen/ premarital anyway) babyproofed her by having 7 years younger sibling, how could we do that for the youngest with no younger cousins or siblings? She has made it to mid 20s without an unscheduled baby; hope like older sibling she’ll get to that in some form or other if that is what she wants.
As I am money manager my spouse chooses blissful ignorance so I am often explaining the nonfeasability/ fiscal folly of me hiring him, him hiring me, Swiss bank accounts, bit coin LOL, pork or timber options, Kruggerands, ignoring tax filing rules, etc. etc. For some reason (maybe me quoting WCI frustration with the salesmen) he never suggests whole life.
Not sure you could justify paying your child to babysit your other child. Allowance and payment for household chores is generally considered not true earned income by most tax pros. I think you just won the audit lottery. I don’t think I’d try/recommend that particular approach. Babysitting for a neighbor is fine though.
Not the exact topic, but I think relevant, payments to the following people are not allowed to be reimbursed as dependent care FSA expenses (https://www.irs.gov/publications/p503):
-A person for whom you (or your spouse if filing jointly) can claim as a dependent;
-Your child (including stepchild or foster child) who was under age 19 at the end of the year, even if he or she isn’t your dependent;
-A person who was your spouse any time during the year; or
-The parent of your qualifying person if your qualifying person is your child and under age 13.
I’d bet those also can’t be considered earned income for the recipient.
Probably not.
Another benefit of having your spouse on the payroll which wasn’t mentioned is allowing for the deduction of the spouse’s business travel and business meals.
An excellent point, but probably not enough to move the needle for most. Relevant to us right now though. Katie went with me to Grand Cayman last month to speak to anesthesiologists and we had to decide how much of her expenses were true business expenses versus her vacationing on my business trip.
Regarding the HSA, can you elaborate on the benefits of funding an HSA via employer withholding vs. doing it personally? I’d like to see some numbers on that, and can’t seem to find it on the site. Thanks!
if your employer withholds you don’t pay payroll taxes on it, but if you contribute directly you can’t deduct from the amount of income that is subject to FICA taxes. Makes a big difference if your income is below the SS tax maximum and a lesser difference otherwise
Although, thinking about it, the closer you are to claiming social security, and the lower your income history, the incremental social security benefit of having the additional HSA earnings may outweigh the benefit of the current deduction of social security taxes. (but we’re talking about a single digit dollars per month difference)
You save payroll taxes on the HSA contribution. So for most docs, that’s just medicare. So 2.9% (or 3.8%) x $8550 for a family in 2025. That’s a max of $325 in savings for running it through payroll. Better than a kick in the teeth.
Another benefit not mentioned is for health insurance. Sure we can do ACA insurance but in Texas, there is no PPO plan. Having an employee allows us to access a good plan thats overall saved us a lot of money. Also we can tax deduct business meals and trips.
You don’t need to hire your spouse to take true business deductions.
Interesting that you could get a significantly better health plan by hiring your spouse. I think our health insurance broker would be surprised by that. Frankly, the plan we have now for us and other WCI employees isn’t any better or cheaper than what we bought when it was just me.
In case of divorce, I would suspect SS and 401k to become more important. Given high rates of divorce, would employment history and benefits better protect lower earning spouse?
SS is the same whether married or divorced and the 401(k)s all get split in divorces. So no, I don’t think hiring your spouse is particularly helpful in that situation. Might even make divorce more likely!
I agree with the article with one exception. If you have a cash balance plan and pay your spouse a low amount like $25,000 per year, that is enough to minimize self employment taxes, so will pay a couple thousand dollars, but then can max out 401k and then be able to contribute even more to your cash balance plan. So a rough estimate would be around $23k in retirement account plus approximately 40% of the salary into cash balance so about 10k. That would be tax savings of around $33k and just have to pay about $2800 in self employment tax. I think that is the only way hiring a spouse makes sense. Anymore additional amount I agree would cost more.
This is very interesting as I have a cash balance plan and hadn’t pursued hiring my spouse for all the points mentioned in Jim’s article. I’m wondering now if the math changes when factoring in the CBP plus the 401k. Is it still the same if your spouse makes 20k? 30K? 50k? What about the megabackdoor Roth options?
I think when you start paying more, it becomes diminishing returns as the self employment tax will start going up more that you will have to pay so it starts to not be worth it.
I might be missing something, but I don’t think you can make a huge DBP contribution without paying someone a lot. But if that’s not true, then yes, this could be a big deal. And of course MBDR takes less income than tax-deferred employer contributions.
I have the following comment/testimonial saved in my notes from a different WCI blog post about Cash Balance Plans (sorry I don’t remember exactly which one):
“I hired my spouse and established a cash balance plan. I did have to pay her a salary, including payroll taxes for 3 years. After that time, I paid her a token salary of about $500 per year. According to the actuary, we only needed 3 years of salary to establish a benefit. I was 48 and she was 51 years old.
The cash balance plan benefits were as generous as the law allowed, including a COLA and an early retirement age. Between me and her, we were able to make contributions as high as $400k per year. No taxes were paid on the $400,000 contributed; although the actuary cost about $3k per year at the time. Even when the funds are distributed, we will not have to pay FICA, Medicare and local taxes and possibly no state income tax depending where we retire.”
Pretty slick. That would change the calculation for sure if you could pay your spouse $500, $3K in fees, and put $400K into a retirement account. Maybe we should do a blog post just about that.
But doing that sort of thing for many years makes you start thinking about having a true RMD problem.
So I decided to ask some knowledgeable people if this was legit (pay $500 in salary and make huge DBP contributions) or not. Here are the responses I got:
# 1
The more one hangs out in the financial world, the more one will see wild stories told, probably by some fringe service providers who have done things worthy of some serious IRS audits. Anything is possible, of course, provided that it is not legal. I’m sure there are plenty of skeletons out there, and people who have no idea of what’s going on often recommending solutions to their clients that are simply wrong. We see this all the time. In fact we are currently unwinding one of the infamous 401h plans (remember that one?). We actually found someone (small practice) with such a plan. If they were to be audited, this would be completely blown up. It was done by a fairly large wealth management firm, and there was no paperwork, nothing at all, just some words, emails and phone calls. It was surreal. But here we are.
Long story short, the answer is no. To get a meaningful benefit one would have to have a W2 that’s maximum (often closer to $345k, especially if the goal is to max out the contribution). And of course the spouse has to be of the appropriate age, so for $200k, they would probably have to be at least 50 years old. I know docs often shop service providers until they find one who does what they want. That’s fine until the audit comes, and these are extremely expensive, that’s for sure. If you have an illustration from a service provider (or a name of one), I can have it reviewed by an actuary, but this is the first time I hear of this (and we work with CB plans every day of the year)…..
I’m not surprised by anything these days. In fact, we’ve actually seen something similar to what you are talking about. A doc came to us with a CB plan where in two consecutive years she was paid something like $25k-$35k a year. The plan was open for a while, and she was contributing the maximum during those years. The actuaries basically said that this is not sustainable. This amounted to an over-funded plan as her W2 was too low to support those contributions. And it was over-funded by a lot because the formula is typically based on W2, so you might have something like 20%-50% of W2, so if W2 falls drastically, the contribution would fall as well. So when the valuation is done for the year, the plan would have been over-funded (unless it was over-funded to begin with, and lowering W2 simply fixed that by making a much lower contribution, which is a possibility, however a doctor with a $25k W2 and high distribution is an instant IRS audit target, so there’s that).
# 2
I am not well versed in how to calculate defined benefit plan contributions, let alone limits.
However, DB contributions limits “are” based on actuarial requirements. For example, generally the “benefit” can not exceed 100% of compensation.
You really need an actuary to look at the specific facts and circumstances (compensation, age, current DB plan assets, years to retirement, etc…) to determine individual contribution limits. I would really be surprised given your facts if the contribution limit is anywhere near $200K.
When the spouse is part of the plan, there are two things that need to happen to max out their contribution:
1) They have to get a meaningful W2. This is at least $5k-$10k.
2) They need to be old enough to be able to make the higher contribution.
So if they are old enough, and their W2 is $5k-$10k, they can get a contribution. If they are older, the contribution would be higher. But in general, their contribution will not be more than a few thousand with a W2 that low. To make a decent CB contribution (~$40k for someone in their early 40s), their W2 would have to be at least $40k-$50k or so. To have them contribute $200k would require a W2 of at least $200k-$300k.
There is no way to have a $200k contribution with a $500 W2. That’s just not how CB plans work. If the owner is 68 years old, they can easily get $400k contribution, while the spouse with $500 W2 will get a tiny fraction of that at most. So because we don’t know how old the owner is and what they are contributing, we can’t draw any conclusions as to what the contribution was for the spouse with $500 W2.
N of 1 here but here it goes.
I’m 35 and wife also 35. Total of 250K in 1099 income. Hired wife and paid her 50k. Was able to contribute about 75k contribution into CBP.
I’m trying to figure out how this calculation is made but nobody seems to be able to show me chapter and verse how to do it. If your example is legal, one can clearly contribute more than you’re paying the employee.
Mega Backdoor Roth IRA contributions help too. You might be able to get $70K into the 401(k) while only paying $80K or so in salary.
If you are hiring your spouse for periodic work that results in overall low payroll wages, and your spouse has room for additional 401k contributions, I think hiring them makes sense. My spouse has no employer 401k. I hire him for part time work so he can make his full 401k catch up contribution (over age 50) and no additional work beyond that. I think employer- paid taxes on this was about 2k last year for him socking away 30500 plus employer match on a fourth of that.
This is what we did last year. My wife made a tad more than 27,000 working on our real estate among other things, and after FICA taxes, she put the max into a solo 401k. Because it was a business expense for us, it effectively lowered our income via schedule E, and we arbitraged the difference between FICA taxes and our marginal tax rate. Win-win
Remember real estate income isn’t generally earned income so be careful there. Make sure you’re not taking something you don’t qualify for.
15% of $35K or so is probably a least twice that. Be sure to count all the payroll taxes.
Benefit #4 (and the most beneficial IMO, if you are planning to pay for childcare anyway)
If you have child or dependent care cost, then you could be eligible for the ~$1200 CDCC tax credit (typically 20% of up to $6,000 in cost) to the extent that both spouses have earned income. This credit outweighs the cost of the extra FICA taxes when considering hiring your spouse.
Also, to elaborate on Benefit #3 making 401k Contributions… In some situations, by a spouse earning ~$7K in it will allow BOTH $7K Roth 401k contributions AND $7K Roth IRA contribution, for a total of $14K in retirement contributions, in essence a “double dip” retirement contribution.
I understand the skepticism, so a detailed example: Early retired couple, both with minimal earned income and a real estate portfolio. Spouse #1 earns ~7K from consulting, and contributes all to a Roth Solo401k. Spouse #2 starts a Property Management LLC and is hired to do all the active property management of their real estate portfolio, and charges a reasonable fee to do so (expensed to Schedule E and income to Schedule C). Yielding another ~7K of earned income, all of which also goes into their own Solo Roth 401k (although “earning” a small amount income could come from any source if you don’t have real estate, as long as you get a 1099 and create a Solo Roth 401k… or use employers Roth 401k). Tax code details in order to contribute to an IRA, you have to have “taxable earned income”, since both of the ~7K Roth 401k contributions are pre-tax, this qualifies, and you can also make an additional IRA contribution of $7,000 each.
By hiring Spouse #2 and earning income of ~7K, it allows for an additional ~14K to get stored away in Roth accounts to grow tax free for years, and come out tax free decades later, and the expense is some FICAs (but CDCC credit may outweigh, see above benefit #4). Obviously, the funds that go into the Roth IRA accounts will have to come from other excess savings/investments, since the actual earned income doesn’t cover it… but money is fungible.
I asked my tax accountant, and researched on various forums, and am confident this Roth 401K & Roth IRA “double dip” is allowed. The key is the 401k contribution MUST BE ROTH… if it were a traditional 401k, there would not be any TAXABLE earned income left to do the IRA contribution. The IRA contribution does not have to be Roth, but probably should. (The standard deduction may be more than the ordinary income (earnings, interest, rents, etc) since this retired couple earns so little earned income, making the Roth selection for the IRA a no-brainer).
This brings in the final benefit. With the couple earning “just enough” ordinary income (less than their itemized / standard deduction $30K) they can then “fill up” the remaining 0% tax bracket for LTCGs (~$94K). Doing this year after year, you can recognize a lot of capital gains, keeping your taxable account basis very high, making it like a MEGA Roth Taxable account, as the basis is ever growing, “paying” 0% tax rates on the gains, leaving little capital gains to recognize down the road.
Sorry for the long comment, but it all kind of ties together. TLDR: retire early, and taxes won’t be a major problem.
Small Typo, but critical….
since both of the ~7K Roth 401k contributions are pre-tax, this qualifies,
It should read….
since both of the ~7K Roth 401k contributions are TAXABLE, this qualifies,
Roths are post-tax accounts, aka taxable income in the year the contribution is made.
Good catch on the typo. I noticed that too this morning. Not sure how it go through our process.
# 1 You don’t need the spouse to have earned income to do an IRA contribution.
# 2 Hiring your spouse so you can pay someone to take care of your child so you can take a child care credit doesn’t seem wise. Doesn’t it cost you more in child care than you’re getting in benefit? If your spouse is already working, you’re already getting this credit. If your spouse isn’t working, have them watch the child while you’re working.
# 3 Most docs aren’t in a position to tax gain harvest. I mean, how many WCIers have income less than the standard deduction?
Hmm… I’m open to being wrong, but let’s talk through the math.
My s-corp paid my wife about 26k in W2 wages… just enough to maximize her 23k 401k contribution, resulting in 4k in payroll taxes (2k in her w2 and 2k from the s-corp).
So it costs us 4k to defer taxes on 23k (otherwise taxed at 35%). It’s not as good a deal as hiring your child, but still seems like a smart financial move. What am I overlooking?
I agree that paying a spouse a higher amount would be wasteful.
Did you miss the part in the piece that you’re just deferring the income taxes but not the payroll taxes, not avoiding them completely? So if you’re saving $8K in taxes now and pay the equivalent of $5K in today’s dollars in taxes later, you’re not coming out ahead paying $4K in payroll taxes.
Hashing this out is helpful. Thanks for the sacrifice.
How much value to you place in tax-free growth? This is also relevant when deciding whether or not to make profit sharing contributions in our 401k (ie. employer’s cost of contributing to each employees 401k plan in order to contribute to my own 401k vs just paying taxes and contributing to a taxable brokerage account)
Funny you ask this, I just ran numbers on this for my presentation at WCICON. It is HEAVILY dependent on the tax-efficiency of the investment. If the investment is VERY tax-efficient, tax protected growth may never overcome the difference between LTCG and ordinary tax treatment even with no fees. But tax-free withdrawals are obviously huge. But as far as additional employee match, if the employee doesn’t value it enough to take less in salary, it doesn’t take much to eliminate any benefit to the owners of using retirement accounts.
Haha. Good luck with your WCICON prep… good timing
Two questions come to mind. First, at what cost is it smart to choose tax deferred accounts? I’m hearing you say that maybe a cost of %15 is too expensive. Or at least seems like the tipping point is right around there.
And a second related question is, do you have a guideline to quantify the tax drag of a taxable compared to a tax-deferred account? I’ve heard to reduce expected returns by 1% but I suppose it needs to factor in the difference between capital gains rates vs ordinary income rates. This gets complicated
Not sure what you mean by 15%. Can you explain more what you’re comparing and what cost you’re talking about?
Tax drag is HIGHLY dependent on the investment, its returns and its tax efficiency. Maximum tax drag is easy to calculate of course, but it’s usually not quite that bad. For example, if the investment returns 10% and pays out all 10% every year as ordinary income (think a real estate debt fund), and your marginal tax rate is 45%, “tax drag” will reduce returns by 4.5% a year. Something perfectly tax-efficient like Bitcoin that you hold for many years will only have LTCG rates applied once at the very end. Let’s say it makes 10% a year as well. So if you invest $10,000 for 30 years, that’ll grow to $174,000. If your LTCG marginal rate is 28.8% like mine, you’ll be left with $124,000. Without any taxes, you could get there with a return of 8.75%. So that’s a tax drag of 1.25%.
So if in the top tax brackets in Utah, expect the tax drag on an investment with a return of 10% to range from 1.25% to 4.5%.
Hope that helps.
Great answers.
Let’s go back to the question of “at what cost is it smart to choose tax deferred accounts?”
The 15% I mentioned was referring to the cost of payroll taxes. Last year, my s-corp hired my wife and paid her 26k… 4k was paid in payroll tax in order contribute 23k tax deferred (note: 35% tax bracket).
Whether the cost is in the form of payroll taxes or 401k fees, or required employee 401k contributions… any guideline on where is the tipping point? Where deferred contributions are no longer worth the cost? And instead a taxable brokerage account is smarter?
There’s no simple answer to that question. It relies on time in the account and tax rates mostly. But as a general rule, if 401(k) related investing fees are less than 2%, it’s worth using the account over taxable. But $4K of $23K is way more than 2% so it’s really a different calculation there.
Wow. 2% is much lower than I was expecting. This is helpful, as I’ve been trying to decide how much profit sharing to contribute to my 401k, but the cost (in the form of required employer contributions) is well over 20%… and it sounds like I should have my wife work for free (her 15% payroll tax is much higher than 2%)
2% and 15% aren’t apples and apples. 15% of what she makes one year may or may not add up to more than 2% a year earned on a contribution. I’m not sure you’re doing the math right.
But you’re right that making huge profit sharing contributions or paying penalties to your employee’s 401(k) accounts may not result in you doing better in the end UNLESS the employees are taking lower salaries in exchange for huge employer 401(k) contributions.
Can you please explain what ultimately limits employer 401k contributions? Assume the business has enough income to clear any limitations related to that. Paying an employee 1 dollar with a $69k employer 401k contribution would be amazing tax wise, but I assume that can’t be done. Is this limit for all employees, or just spouses?
All employees. You can’t put more into a 401(k) than they’re being paid.
I do the math a little differently- I employed my wife last year and paid her about 26k. Payroll taxes last year were just about $3800 for her. Living in Oregon our marginal tax rate is 41.9% (yay Oregon). Using a traditional 401k we saved $9,637 in income taxes minus the $3800 for payroll taxes and some extras you noted for fees/accounting/cpa etc so I’ll round to $4000. Seems like we have an extra $6327 a year to invest that we would otherwise pay to uncle Sam and State of Oregon. Obviously that becomes a substantial amount over 25 years invested. Yes we pay regular income tax on that later and don’t know what that is but it’s not 100% so we’re still ahead right? I don’t know why you’d pay your spouse $100k if the sole purpose is basically to gain access to another 401k contribution- the math seems to work out just fine with a high marginal rate and paying just enough to max out a 401k. Am I missing something?
No, you’re not necessarily ahead. You’re doing the math wrong. Maybe you’re ahead, but not by nearly as much as you think. That’s the point of this article. If you pull that $6,327 out at the same tax bracket as you put it in, all you got was the benefit of tax protected growth. Worth something, but not that much. Maybe not worth the $3,800 in payroll taxes. If you get a big arbitrage between the tax rates, it probably is worth it. My point is that it isn’t the no-brainer that people seem to think it is, even when it’s a situation like yours. It would be even worse if you paid your spouse $120K unless you did a MBDR.
This is essentially my same situation I am in.
As a rule of thumb then, the cost of of the 401k (eg. the payroll taxes to hire the spouse) must be less than the expected savings from tax rate arbitrage PLUS the value of tax free growth (estimated 1% of amount invested x # of years). Otherwise, you’d recommend a taxable brokerage account?
Exactly. You can also add in the benefit from those additional payroll taxes if any. 1% is a pretty low estimate for the value of tax protected growth and a very low estimate for the value of true tax free growth with tax free withdrawals.
It’s just not the no-brainer a lot of docs would think after listening in to conversations in the doctor’s lounge. It’s not hard to come out behind doing it. I mean, imagine you pay your previously non-working spouse $100K that otherwise would have been an S Corp distribution from your practice. That’s $15K in additional payroll taxes. And your spouse puts $23.5K into the tax deferred 401(k) and gets a 3% match. So $26.5K in there. Your marginal tax rate is 32% now. So you save $26.5K*32% = $8,480 in income taxes this year. That’s not awesome. And you’re only deferring that $8,480 in tax and getting tax protected growth on $26,500 unless you pull that money out later at a lower rate. How long does $26,500 have to grow at 10% instead of 8% a year in order to make up $15K? About 13 years. It would take much longer at lower rates of return of course.
Easier to run the numbers on a Roth account. Assume you earn 10% a year in the Roth and 8% a year in taxable. Now let’s say you pay $15K in worthless payroll taxes to get $70K into a Mega Backdoor Roth IRA. You pay for that $15K cost in just 7 years. But I don’t think most people hiring their spouse are doing $70K Roth contributions on their behalf. And this all assumes your spouse is being paid reasonably for legitimate work, which is the most common issue I’m seeing with docs setting this up. The spouse isn’t actually doing squat. It’s just fraud.
Overall agree with the article but I think there are exceptions.
I have a side gig making 250k via 1099. Recently hired my wife and pay her 50k.
We have a custom solo 401k that allows mega back door roth. We also have a cash balance plan. Yes I need to pay payroll tax on the 50k, however, we’re able to put 23.5k in tax deferred, 26.5k in Roth, and an additional 100k into the cash balance plan.
The cash balance plan makes all the difference in this case.
It may not be worth it based on marginal tax rate at withdrawal but I think it at least makes it a consideration.
I agree there are exceptions to the general rule that this isn’t a huge score tax-wise.
I’m not convinced your set-up is legal though to pay your wife $50K and put $23.5K as an employee contribution, $26.5K as an after-tax employee contribution, and then $100K into a cash balance plan for her. See comments above for details.
Not sure this argument is valid if you have a Defined Benefits Plan setup through your office
Lots of discussion about this in the comments above and possibly a follow-up post.
My main gig is a W-2 job where I make around or slightly above the SSWB. My wife’s main gig is a 1099 independent contractor job making around $350k. I am the financial manager of our family, preparing personal and her business taxes, managing investments in her custom solo 401k and elsewhere, administering her plan, tax planning, doing her bookkeeping and payroll, and even doing some unpaid financial consulting with her group. It didn’t make sense for her business to hire me as an employee, mostly due to the lost employer Social Security taxes. But, I recently got a side gig doing some unrelated consulting. The pay wasn’t a lot, but to me it allowed her business to hire me as an independent contractor. The big advantages were: (1) I could contribute my Schedule C profits into her 401k as MBR which net to around $15k/year, (2) I could deduct a few expenses I wouldn’t otherwise be able to (home office, computer, etc totaling a few thousand dollars), (3) there are no payroll costs, and (4) no loss of employer Social Security taxes. I need a business license but I already have one for the other consulting. The 199A deduction canceled out because she loses the deduction but my profits are deductible. Basically I’m able to contribute into a Roth account or the low low price of 3.8% of whatever pay to me can be reasonably justified. May be a little aggressive but I think it’s defensible. I’m talking to her group now about doing some more consulting for their wellness website, and her business can pay me for that too.
Nice. Glad it works out so well for you. As you can see, your situation isn’t exactly common though.
Did you come to a conclusion regarding defined benefit plans/cash balance plans, how they can legally be used for spouses and earned income, and how to calculate their limits? Or any resources or contacts that are familiar with these plans? It seems like this is the main determinant of whether paying your wife to work is a good idea. My wife currently works “for free” in my business doing the books and variable admin work for both of my practices. However, if we could shelter more money in a cash balance plan, that would tip the balance to looking into actually paying her an income. The $ value of what she does is actually quite immense vs. what I would have to pay someone else to do everything she does, and could easily reach close to $100k to pay accountants and admins to do it, so there is a strong incentive for us if there are options out there to defer or shelter more money from taxes. Also, say we could put a maximum amount into a mega backdoor Roth IRA for her through the 401k, wouldn’t the 12-15% loss of additional payroll taxes be more than made up for with 20-30yrs of compounded gains tax free at the end?
You also get compounded gains in a taxable account, which can be invested very tax efficiently in many cases. So it’s all about the other benefits in the account vs the additional payroll taxes, which are quite substantial if she’s not already over the SS wage limit.
It is possible to put A LOT of a non highly compensated employee’s wages into a DB/CB plan. For example I made just over $100K last year as a doc but put $60K into the DB plan and there was no issue. So it can be done, you just have to run the numbers with some reasonable assumptions to see if it’s worth it.
Well, in this scenario, we are having a very good year in our practice, and if it continues, will likely have a substantial portion of our business income in the highest income brackets. I am only in my early 40s and wife in mid 30s, and the question becomes what do we do with that additional income to make it more tax efficient. I have the 20% deduction from the scorp, then about another 10-20% in depreciation we can use from the practice equipment we purchased, 401k (have 10 employees so cant do solo), and some planned charity/donations, but after that, we really don’t have anything setup to accomodate the rest of the income without paying around 40% taxes on it with. There is equipment I could purchase to reduce the taxable income that will generate additional ROI that makes sense for the business, but that equipment does not really hold its value longterm and is difficult to resell in a niche market. My wife works as part of the administration and does the books for the business, but we currently don’t pay her any income. It seems like it doesn’t make sense to pay her for her to have a 401k due to the reasons you mentioned, but how would you calculate out a potential gain from a cash balance plan in this scenario? Adding 12% tax, reducing 40% temporarily nets 28% up front gain. What do you think about this, or what would your estimates/calculations say about this scenario?
# 1 It’s okay to pay taxes. We pay lots and lots of taxes. It’s a great problem to have because it means you’re making a lot of money. Yes, our marginal tax rate is around 45%. Heaven forbid you’ve got to pay your part of welfare or aircraft carriers or interest on the debt or whatever.
# 2 Never let the tax tail wag the investment or the business dog. It’s fine to do a little tax planning around the edges, but when the primary goal is to pay less in taxes you’re probably doing it wrong.
# 3 A DB/CB plan is a GREAT way to defer more in taxes. Make sure you actually want to do that. I mean, you could eventually convert whatever tax-deferred money you have, but you’re just deferring taxes and if you can’t convert or withdraw them at a similar or preferably much lower rate later, you’re probably not coming out ahead. But sure, run the numbers on putting your spouse on payroll and starting a DBP. Bear in mind your retirement plans will still need to pass nondiscrimination testing or you’ll be taking the money you would have been paying in taxes and paying it to your employees’ retirement accounts as a penalty.
Really interesting article Jim. Articles like this often have a big assumption (reasonable of course): the spouse proposed to be hired makes either $0 or materially less than the hiring spouse. I have the reverse issue.
I own a solo psychiatry practice (S-corp: ~$85k per year W-2/~$200k distributions). My husband is a partner in a large law firm (K-1 self employment income per year = $3.5-4MM, has a fully maxed out 401k + profit sharing + cash balance plan). My husband actually does legitimate work in my business – he handles all legal, compliance, some tax etc, but for now it is gratis and without wage. We live in a high tax state so our marginal state income tax rate is almost 11%; so 48% marginal between fed/state.
I have considered if I should hire him and pay him a wage so we can shelter more via my solo 401k. Since he is already well above the SS wage base, paying him via W-2 would have incur some Medicare taxes. It would also include some modest UI/workers comp taxes and increased payroll/accounting services cost. But deferring more money at 48% marginal to theoretically take it out decades later at a marginal rate in the 20s or even 30s% seems like a no brainer.
Was curious as to how the 401k limits work for a my husband in the above situation – he maxes out the employEE portion of his law firm 401k (so i assume he can’t use an EE deferral for my practice 401k plan), but can he still get ER profit sharing contributions and use after-tax non-Roth contributions? I don’t think there are any affiliated/controlled group issues since no matter what he does not control his law firm – hes a ~0.5% owner of a billion dollar firm).
Does this make sense at all? Or am I just wasting time and money thinking about it?
Thanks in advance for taking the time!
Yes he can. But if you hire him as an employee, you are at last going to pay half the SS taxes (with no benefit to him). So I’m still not sure it’s going to work out in this case. If you weren’t an S corp you could make him an owner and avoid that, but then you’d lose the S Corp benefits. More info here:
https://www.whitecoatinvestor.com/why-an-s-corp-doesnt-mix-well-with-a-w-2-job/
Hmm… I read that article but still didn’t quite follow.
I understand if someone has two different W-2 jobs (so a day W-2 job and now getting paid from the S-corp as a second W-2) and is above the SS wage base, the employer half is paid twice (with no refunds). But my husband is a K-1 partner at his primary job, so he has no W-2 income. Without the W-2 he pays the maximum SS amount via estimated tax payments quarterly.
How is this situation different than your situation outlined in that link (two K-1s and one W-2)? Or am I overlooking/misunderstanding something?
Really appreciate your time!
Oh, nice. Then yes, I think you’re an exception. All it will cost you is the additional Medicare tax and that’s probably worth it .And if he’s doing the work anyway….