When you own your own practice setting your salary seems like a no-brainer. Pay your bills, pay your taxes, pay your staff and what’s left goes home with you. If only it were that simple.
It turns out there’s a lot more that goes into determining an owner’s salary than most dentists realize. If you are incorporated, you have to decide how much to take as a W-2 wage. You need to maintain a consistent personal cash flow even if the practice’s cash flow is tight. The amount you take home even affects your retirement planning. Then you must consider that tax rates can also vary based on if you pay yourself in W-2 wages, or some other type of distribution.
Emmanuel Miller, a CWA registered investment advisor and CPA, understands there are a lot of factors that could leave you with questions, especially when you consider the tax implications one’s determined salary can have on the actual take home amount. Emmanuel says it shouldn’t be a guessing game, and shares three things every practice owner should consider when determining their salary.
1: There are different types of ways to pay yourself
There is no universal percentage an owner should pay himself or herself. It’s an extremely personal number typically composed of a combination of W-2 wages and distributions from the business. You want to find the right balance between personal and business cash flow. Then you also have to factor in lifestyle expectations and retirement ambitions.
Many times, W-2 wages are seen as a doctor’s means to get money home. While this is one way the doctor can get money from the practice, there are other ways to consider. Your W-2 wages must pay Social Security (12.4%) and Medicare Tax (2.9%). Withholding from wages is also the most common way to pay your federal and state income taxes, as opposed to quarterly payments. Lastly, if you have a retirement plan that allows for salary deferrals like a 401(k) Plan or a SIMPLE IRA, these must be withheld through payroll.
In addition to wages, you may be able to take distributions from the practice. This is not run through W-2 wages and therefore are not subject to the Social Security and Medicare tax. This can save as much as 12.5% on employment taxes. Please note, there are tax situations that can arise that preclude a shareholder from taking a distribution. As such, you need an advisor to help you with this balance.
It is only by looking at one’s global picture that we can help you determine a salary that lets you live well today, and meet tomorrow’s obligations while building a comfortable future. At the end of the day it’s your money, but you owe it to yourself and your practice to manage it wisely
2: Minimize taxes and maximize retirement contributions
The IRS annual compensation limit for anyone to maximize their personal 401(k) deferral and employer contribution in 2018 is $275,000. Considering that every dollar you pay yourself through payroll is subject to payroll taxes, in most cases, it doesn’t make sense to pay yourself one penny more than $275,000 in W-2 wages if you are running a retirement plan.
After maximizing 401(k) salary deferrals and withholdings for taxes on a $275,000 salary, some of our clients need additional income to maintain their lifestyle. To supplement, take the rest of what you need as distributions from the business. Depending on your business structure, your additional take home will be taxed as ordinary flow-through or dividend income not subject to payroll taxes.
If you are not running a retirement plan, you do not need to hit the $275,000 for pension purposes. You can lower your wages and save employment taxes. You do need to beware of lowering to an unreasonable level for your position/production as this could be an audit trigger. Consider industry averages for associate doctors with your same productivity levels. If you set a lower salary and need more income at home, you may also be able to take distributions to supplement.
3: Beware of lifestyle creep
It’s tempting to take larger distributions if you’ve had a great year or even after a great period. This may not be the appropriate step. First, you must consider the tax consequences to the increased income. You want to make sure you set enough aside for this. Additionally, one or even several great years doesn’t mean that next year won’t be tight.
By having a consistent balance between your salary and distributions, you can continue living within your means and avoid the lifestyle creep trap. Once money goes home, it’s gone. The smarter play is to put that extra money to work for you. Instead of a new car, invest in new equipment for your practice, real estate, or other alternative investments that you have discussed with you financial advisor. Not buying that boat could set you up for a retirement’s worth of luxury cruises.
Setting your salary and determining if you need to take distributions is tough. With over 30 years and 1900 clients, our advisors have the experience working with dentists on this exact topic, among others. As tax laws change, business cycles fluctuate and personal expenses evolve, setting your personal salary is an essential way to assure your business works for you.