What is the ROI of incremental Self-Employment taxes?

By taking GCC truly global and incorporating overseas, we can completely eliminate Self Employment taxes.

Although this is only one of many factors to consider, these pesky payroll taxes take 15.3% of every dollar of profit we make on this little blog. All else being equal, I would rather pay $0 than $5,000+.

But of course, all else is not equal. Fewer dollars paid in Self Employment taxes will result in smaller Social Security checks down the road. (Checks? I’m definitely dating myself.)

Even though I know Social Security is generally poor value for early retirees… since I won’t even change brands of toothpaste without a little research, I guess I better do the math.

What is the actual return for continuing to pay (now optional) Self Employment taxes?

SS Benefits Determination

The Social Security Administration does their part to help you determine future SS income by providing a great number of acronyms, formulas, and calculators. If you are interested in jumping down that deep dark well, Justin at Root of Good provides a great explanation of how Social Security benefits are determined.

Here are the Cliff Notes:

Social Security benefits are based on average indexed monthly earnings over 35 years, so an additional $420 of income increases the average by $1.

For every $420 in lifetime income:
– You pay $32.13 in payroll taxes (7.65%, 6.2% for Social Security, 1.45% for Medicare)
– Your employer pays $32.13 in payroll taxes
– Your future real monthly Social Security check increases by $0.15, $0.32, or $0.90

The actual monthly increase is a function of total lifetime income:
– First ~360k of lifetime earnings, $0.90 per $420 (SS ~$770/month)
– Second ~1.8 million of lifetime earnings, $0.32 per $420 (SS ~$2,146/month)
– Final ~2 million of lifetime earnings, $0.15 per $420 (SS ~$2,854/month)
– Additional earnings or income greater than $118,500 (2016) in any one year don’t have an impact on SS income.

This is the base income calculation for Full Retirement Age (for me, Age 67). Choosing to take SS “early” or “late” will decrease/increase monthly income.

Maximum Return

While the Social Security Administration formulas and acronyms tell us how much $ we may receive, for value, more important is when.. when we paid the taxes, and when we receive the benefits.

Naturally it is more rewarding to receive income now versus 30 years from now.

If we wanted to maximize return on our Social Security investment (taxes), we could (in theory):
– never work (in the US) until 10 years before SS eligibility
– work for no more than 10 years (minimum qualifying credits)
– earn no more than $360k (top of the 90% “bend point”)
– start receiving SS benefits immediately upon qualification (after 10 years of work)

In this scenario, we would pay ~$2,750 in annual payroll taxes for 10 years and then receive ~$9,000 in annual income for life.

Knowing the exact value of the resulting income requires knowing when we will die… For better or worse I don’t have that information. But thanks to our friend mathematics, we can forecast potential ROI by calculating the Internal Rate of Return (IRR) for a cash flow series (taxes paid and income received.)

For an immigrant or late bloomer, the ROI is impressively high… After just 2 years of SS income, we’ve already received more in income than was paid in taxes (“employee” contribution only.) By age 80, the IRR is an impressive 14.4%, above and beyond inflation. Contrast that with the US stock market which has returned ~7% over the past 40 years.

The return is even better when we factor in that 20% of the payroll taxes are to buy a ticket for the Medicare bus.

Early Retiree Social Security Return

A typical early retiree works less than 35 years and has a large gap in time between work and Social Security income, so Social Security ROI is much less impressive.

Using the exact same earnings as the late bloomer above (10 years, $360k), but with income earned decades earlier, the ROI plunges to single digits.

Extra Income in Early Retirement

In my 24 years of “work” (16 in my career and 8 during high school/college) I’ve earned more than the first Social Security bend point (~$360k) and less than the 2nd. At best, every $420 of additional income will earn $0.32 in monthly Social Security income… someday. Most Early Retirees will be in a similar boat.

If extra income does make an appearance, it is likely to be due to “Self Employment.” This means we must pay both the employee and employer payroll taxes, 15.3% in total.

How does this materialize in terms of ROI?

The ROI on the SE taxes I’m paying in my 40s reaches break even at around Age 83. Unfortunately, the Social Security people think on average I’ll be dead by Age 80. That’s nice.

However, if I beat the odds I may eke out a small real positive return of 1% by age 90 and 1.8% by age 100. That is better than my savings account. (Technically, the SS actuaries give me a 80% chance of living to age 67, a 50% chance of living to 80, a 20% chance to 90, and a 0.9% chance to 100.)

By contrast, making a one time contribution to a diversified portfolio of stocks (7% real return mas o menos), it would potentially grow by over 5x by Age 67 (and 13x! by age 80.) Or instead of increasing monthly income by $0.32 from SS, it could instead be $1.16 (4% Rule) starting at age 67.

And whereas the Social Security benefits cease with our final breath, our stock portfolio does not. (And then there are taxes…)

What about “Normal People”?

Not everyone is an aspiring early retiree (I know, right?!) How does SS ROI look for them?

I plotted the IRR for lifetime income equal to each bend point over 35 years.

SS is a progressive system, so the higher your income the worse the return… although it isn’t great for anybody except below poverty level (~$10k/year income for 35 years.)

Returns decrease for anybody working longer than 35 years, as only the taxes paid in the highest earning 35 years count.

Final Thoughts

As suspected, the potential for increased Social Security income based on additional post-retirement earnings is not good. In truth, SS IRR is poor for everybody except very low income people, late bloomers, and Lazarus Long.

Poor return on investment is not my favorite thing in the world, but it is nice to know that if I live long enough, I’m effectively just giving the US government a low interest rate loan. And they are taking all of the inflation risk. Hopefully my low stress early retirement lifestyle helps us beat the odds.

Some Caveats:
– Notably, in all cases the ROI for death prior to initial SS income is -100% (bigly)
– ROI can be increased by delaying SS income, assuming you live long enough (see Kitces.)
– ROI is reduced by taking SS early
– I haven’t estimated survivor benefits… if W outlives me by a large margin, ROI increases (slightly.)
– Social Security ROI could be changed at anytime by governmental edict. Most likely downward. (I like JL Collins’ thoughts on this.)
– Returns are “real” (adjusted for inflation)

Does Social Security seem like a good deal?