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 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
Reason #1 – 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.
As a preliminary matter, I always believe it’s a misconception that the spouse is considered ‘non-working’. A spouse is always an integral part of a business…no doubt about it. The spouse should also 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 2020 the primary business owner and their spouse can EACH contribute up to $19,500 (or $26,000 if over 50) into a 401k, and while the business is allowed to take a tax deduction for the W-2, neither spouse has to claim the contribution as income on their 1040 (if a traditional contribution and not a Roth).
Yes…there is some FICA or payroll tax due on the W-2 amount for each spouse in order to ‘fund’ the 401k, but the ultimate tax benefit is significant due to the ‘time value of money’ and building a tax-deferred retirement account. Typically, it’s customary to ‘gross-up’ the payroll amount on the spouse to cover the FICA taxes and then ‘zero out’ the rest with the contribution to the 401k.
For example, if your spouse is under age 50, the payroll amount would be approximately $23,022, with a net pay of $19,500. Then the spouse would elect to ‘defer’ or contribute $19,500 to the 401k, and the W-2 nets out at zero.
This is an incredible opportunity for the spouse of a business owner to create and fund a 401k with a net taxable income of zero!
But it gets better!! In addition to the deferral the spouse could make from their paycheck, the company can also do a match on the total payroll amount to the spouse. This would further be a deduction for the company and add to the spouse’s 401k balance.
In the same example above, the company would ALSO be able to contribute 25% of the spouse’s payroll amount of $23,022, (approximately $5,756) into the spouse’s 401k. The company would have a tax deduction of $28,778, and the spouse would have a balance of over $25,256 in their 401k with no personal taxable income to boot!
In fact, if a business owner and spouse can afford to pay a little more in taxes, they can get even more creative and fund a ROTH 401k and create tax-free accounts, rather than just deferring taxes until the future.
Reason #2 – The Spouse could be the key to writing-off more medical expenses 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 sister management company (typically a Sole-Proprietorship).
It’s important to note that the HRA strategy is impossible for a business owner to use with their S-Corporation without the use of the Sole-Prop. The reason being is the “greater than 2% shareholder rules” that prevent a business owner (or their spouse) from deducting certain fringe benefits for themselves (this includes the HRA). However, the ‘backdoor 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 relationship provide for an HRA.
On the face of it, the HRA may sound complicated or expensive, but it is rather quite simple and affordable. It is ‘self-administered’ without the need for an insurance company or bank’s involvement, and the cost is under $400 at our law firm KKOS Lawyers, or accounting firm K&E CPAs. However, we always want to consider a cost-benefit analysis and you can learn more about these plans at: “How an HRA can Save you Thousands when facing extra Health Care Costs”.
The beauty of the HRA plan being provided through an employment arrangement is that the payroll may be minimal, OR it can be used in conjunction with a larger payroll amount and a 401k contribution.
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”, and compare the HRA to the Health Savings Account and other health care strategies.
* To sign up for Mark’s weekly Free E-Newsletter and receive his Free E-Book “The Top 10 Best Tax Saving Secrets Everyone Should Know” visit www.markjkohler.com.
Mark J. Kohler is a CPA, Attorney, co-host of the Radio Show “Refresh Your Wealth” and author of the new book “The Business Owner’s Guide to Financial Freedom- What Wall Street isn’t Telling You” and, “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP.