This is a very important question and something we often analyze for clients in our office. In fact, many clients rush to put their spouse on payroll, but for the wrong reasons and it could actually be a costly mistake.
First, here are two big reasons NOT to put your spouse on payroll. These are actually common mistakes or misconceptions on why one may put cut the non-working spouse a check.
So the non-working spouse can contribute to an IRA – Wrong. A non-working spouse does not have to have a ‘paycheck’ in order to contribute to a traditional or Roth IRA. The non-working spouse can create what’s called a Spousal IRA. There are really only two requirements. One, the working spouse has eligible compensation that’s at least as much as the total contribution to the both IRAs; and two, they file a joint income-tax return. Bottom line, don’t cut a paycheck to simply fund an IRA or Roth IRA.
To get a Social Security benefit for the non-working spouse – Wrong. On the face of it, this would seem logical, right? Paying into Social Security so that your spouse will at least get some benefit in the future when they turn 59 1/2. However, this is very misleading. For example, a “non-working spouse” of a “working spouse” already qualifies for spousal benefits. Now, although these benefits are limited to 50% of the working spouse’s primary insurance amount, it could actually be best to opt for just the 50% benefit. Speak with a financial advisor that understands Social Security planning to ‘run the numbers’ before rushing to cut another payroll check. I also cover this topic in depth and dedicate an entire chapter to this strategy in my book written with Randy Luebke: “The Business Owner’s Guide to Financial Freedom- What Wall Street Isn’t Telling You”.
Now although there are reasons not to put your spouse on payroll, I would argue there are two (2) GOOD REASONS to put a spouse on payroll before year-end. Both of these strategies create great excellent tax deductions and good use of money
First, is the goal to maximize the spouse’s 401k contribution.
There is no such thing as a ‘Spousal 401k contribution’, like there exists for the IRA. Thus, in order to put away the big dollars, the business owner and their spouse need to consider the 401k and create an actual payroll for the non-working spouse.
Now, as a preliminary matter I always believe the spouse is truly not deemed ‘non-working’. The spouse would certainly be serving on the Board of Advisors or Directors for the company, and they would presumably be constantly involved in the operations of the company. Thus, the salary would be justified and appropriate.
Also, it’s important to note that this strategy most typically involves a ‘Solo-401k’ (but can also be used with a ‘group 401k’ with other employees, but to not to as great an effect). A Solo-401k is designed for a company with no outside employees, but the owner and their family. See more information and videos about the Solo-401k here.
This year in 2019 the primary business owner and their spouse could EACH contribute up to $19,000 (or $25,000 if over 50) and the Company take a tax deduction for the W-2, while the spouse doesn’t claim any income on the W-2. Even though you pay some FICA or payroll tax on the W-2 amount in order to ‘fund’ the 401k, the ultimate tax benefit is significant due to the ‘time value of money’ and the opportunity of the spouse to create and fund a 401k. Typically, we would ‘gross up’ the payroll amount to cover the FICA taxes and then ‘zero out’ the rest of the contribution. For example if your spouse is under age 50, the payroll amount would be approximately $22,350, with a net pay of $19,000. Then with the $19,000 deferral, the W-2 nets out at zero.
In addition to the deferral the spouse could make from their paycheck, the company can also do a match on the total payroll. This would further be a deduction for the company and add to their 401k balance. In the example above, in a Solo-401k this would equate to 25% of the payroll amount of $22,350, or approximately $5,500. Just for 2019 alone, the company would have a tax write-off of over $27,850, the spouse would have a balance of over $24,500 in their 401k and no taxable income to boot!
In fact, if you can afford it and want to get even more creative both the business owner and/or the spouse, they could fund a ROTH 401k and create a tax free account, rather than just deferring taxes until the future.
Second, the spouse could be the key to more medical expense write-offs with a paycheck.
Essentially, if your family has a lot of medical costs, putting your spouse on payroll may allow you to utilize the 125 deduction or Health Reimbursement Arrangement (HRA). However, keep in mind that you would have to utilize a Sole-Proprietorship (something I call a ‘family management company’) or a C-Corporation.
Otherwise stated, the HRA strategy is impossible for a business owner to use with their S-Corporation without the use of the Sole-Prop or C-Corp. The strategy is to create a ‘support’ or ‘management’ company that would hire the spouse for services provided to the main company, and under this employment provide for an HRA.
On the face of it, the HRA may sound complicated or expense, but it rather is quite simple and affordable. It is ‘self-administered’ without the need for an insurance company or bank’s involvement, and the cost is under $500 at KKOS Lawyers. However, we always want to consider a cost-benefit analysis and we typically see it make sense for a family with more than $5,000 in out of pocket medical expenses (over and above insurance premiums). You can learn more here at: “How an HRA can Save you Thousands when facing extra Health Care Costs”.
The beauty of the HRA (Health Reimbursement Arrangement) is your payroll need only be minimal and this is not a ‘use it or lose it plan’, but a reimbursement plan that can allow a couple/family to deduct almost all of their medical expenses at any age.
I discuss both the 401k/Spouse payment strategy and the Health Reimbursement Account more fully in the 2nd Edition of my book “The Tax and Legal Playbook – Game Changing Solutions for the Business Owner”. strategy more fully in my new book “The Tax and Legal Playbook” and compare the HRA to the Health Savings Account and other health care strategies.
Mark J. Kohler is a CPA, Attorney, Radio Show host and author of the new book “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions” and “What Your CPA Isn’t Telling You- Life Changing Tax Strategies”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP. For more information visit him at www.markjkohler.com.