How the Social Security Wage Base Impacts Investment and Retirement Planning

The Social Security system in the United States is a vital part of the nation’s safety net, providing retirement, disability, and survivors’ benefits to millions of Americans. A key aspect of Social Security is the wage base, which determines how much of an individual’s earnings are subject to Social Security taxes. This wage base changes annually based on inflation and has far-reaching implications for tax planning, especially for individuals with higher incomes. For those earning beyond the wage base, understanding how it operates can open up unique opportunities for diversifying retirement assets.

This essay will explore how the Social Security wage base works, discuss its impact on retirement planning and present a case study of an individual making $230,000 per year. We will illustrate how this person can strategically adjust their retirement contributions to a Roth 401(k) once their income exceeds the wage base, thereby optimizing their tax situation without negatively affecting their cash flow.

Understanding the Social Security Wage Base

The Social Security wage base represents the maximum annual earnings that are subject to Social Security payroll taxes. In 2024, for example, the wage base is $168,600. Any earnings above this threshold are not subject to Social Security taxes (though they remain subject to Medicare taxes, which have no wage limit).

For 2024, the Social Security payroll tax rate is 6.2% for employees and 6.2% for employers, totaling 12.4% on earnings up to $168,600. For example, if an individual earns $230,000, they will pay Social Security tax on the first $168,600, and no Social Security tax on the remaining $61,400 of their income. This creates a tax savings opportunity for high-income earners because they effectively get a “raise” after reaching the wage base.

Understanding when and how much of your income surpasses the wage base can help in retirement and tax planning, particularly in deciding when to shift retirement contributions from tax-deferred accounts like traditional 401(k)s to tax-exempt accounts like Roth 401(k)s.

Planning Opportunities: Diversifying Retirement Assets

For individuals earning above the Social Security wage base, the portion of income that is no longer subject to Social Security tax can be strategically reallocated toward other financial goals, including retirement savings. One of the most significant opportunities is diversifying retirement assets by transitioning from traditional, pre-tax retirement contributions (such as a 401(k)) to Roth contributions once income exceeds the wage base.

Traditional 401(k) vs. Roth 401(k)

The primary difference between a traditional 401(k) and a Roth 401(k) lies in their tax treatment:

• Traditional 401(k): Contributions are made with pre-tax dollars, reducing taxable income in the current year. However, withdrawals in retirement are taxed as ordinary income.
• Roth 401(k): Contributions are made with after-tax dollars, meaning they do not reduce current taxable income. However, qualified withdrawals in retirement are tax-free.

For high-income earners, the decision to contribute to a traditional 401(k) versus a Roth 401(k) hinges on their current tax rate versus their expected tax rate in retirement. If they expect to be in a lower tax bracket in retirement, traditional 401(k) contributions make sense. However, if they anticipate being in a higher tax bracket later in life or want tax diversification, Roth contributions can be advantageous.

Benefits of Switching to a Roth 401(k) After Reaching the Wage Base

After reaching the Social Security wage base, high-income earners can leverage the extra cash flow (due to no longer paying the 6.2% Social Security tax on earnings above the wage base) to make Roth 401(k) contributions. This shift allows for tax diversification in retirement accounts, meaning some assets will be taxed at withdrawal (traditional 401(k)), while others will grow tax-free (Roth 401(k)).

By transitioning contributions after exceeding the wage base, individuals can fund Roth accounts without decreasing their overall take-home pay. In other words, the “extra” income freed up by reaching the wage base can offset the fact that Roth 401(k) contributions are made with after-tax dollars. This can provide a helpful behavioral hack to those who may be tempted to spend the extra income that hits their paycheck each month. By allocating money to the Roth 401k that previously went to the government, you are able to save money tax-free for the future and still see minimal impact on your month-to-month budget. 

Case Study: Planning for an Individual Earning $230,000

Let’s consider a case study of an individual named John, who earns $230,000 per year in 2024. John is 45 years old and has been contributing approximately $19,000 to his traditional 401(k) for several years. He’s interested in diversifying his retirement portfolio by adding Roth contributions but doesn’t want to affect his current cash flow.

Breakdown of John’s Situation

• Annual Salary: $230,000
• Social Security Wage Base (2024): $168,600
• 401(k) Contribution Limit (2024): $23,000 for those under age 50; $30,000 for those over 50 (including catch-up contributions).

John’s Current Tax Situation

• John’s current contributions to his traditional 401(k) are made with pre-tax dollars, reducing his taxable income by $19,000.
• On the first $168,600 of income, John pays 6.2% in Social Security taxes, totaling $10,453.20.
• Once John’s earnings exceed $168,600, the remaining $61,400 is free from Social Security tax, creating an additional $3,806.80 in disposable income.

Strategic Roth 401(k) Contributions After the Wage Base

John decides to transition from pre-tax traditional 401(k) contributions to Roth contributions for the remainder of his income after surpassing the wage base. Here’s how the numbers would work out:

• From his total earnings of $230,000, $168,600 is subject to Social Security tax, and $61,400 is not.
• John saves $3,806.80 in Social Security taxes on the portion of his income above the wage base.
• He reallocates this tax savings toward Roth 401(k) contributions, which brings his total contribution for the year to $22,806.80. Since Roth contributions are made with after-tax dollars, he will effectively continue contributing the same amount toward retirement without affecting his take-home pay.

How This Affects Cash Flow and Tax Deductions

• John’s total cash flow remains largely unchanged because the additional income from not paying Social Security taxes on earnings above the wage base offsets the fact that Roth contributions do not reduce taxable income.
• His overall tax liability might increase slightly because he is making after-tax contributions to the Roth 401(k) and forgoes the small amount of additional deduction that was lost in changing his election, but the long-term benefit of tax-free withdrawals in retirement makes this an attractive trade-off.

By employing this strategy, John can diversify his retirement savings between traditional and Roth accounts. His traditional 401(k) will still offer tax deferral benefits, while the Roth 401(k) provides tax-free growth and withdrawals, thus creating a more balanced retirement portfolio.

Long Term Impact of utilizing this strategy

If John employs this strategy starting at age 45 and only contributes to Roth after the wage base (keeping his salary in lockstep with the inflationary adjustments for wage base for the sake of example), he will have saved $191,949.97 in Roth dollars by age 65 (*assuming an 8 percent return compounded annually and continued additions each year). The is a meaningful impact in diversifying his investments for retirement. 

The example above assumes a pay schedule of every two weeks and implementation of this for others may vary depending on the pay frequency. This would be particularly relevant for those who believe their income will continue to rise year after year. 

This strategy can be combined with saving into other tax favored vehicles such as a health savings account. If John were already maxing out his HSA (as an individual filer) for 2024, then the deduction he receives on the HSA contribution ($4150) virtually cancels out the forgone deduction by switching to Roth elections ($3806.80) thereby keeping his total deductions close to what they would be if he only contributed to a pre-tax 401(k) and not implemented the other two strategies. 

Medicare Tax Implications

It is important to note that while Social Security taxes cease after the wage base, Medicare taxes continue to apply to all earned income. Additionally, there is a 0.9% additional Medicare tax for high-income earners on wages over $200,000 (for single filers). This tax will still apply to John’s earnings above $200,000, but it is a much smaller burden compared to the Social Security tax.

Long-Term Tax Strategy

By diversifying his retirement contributions between traditional and Roth 401(k) accounts, John gains flexibility for future tax planning. In retirement, he can withdraw from either account depending on his tax situation. For example, if he needs to keep his taxable income low to avoid higher Medicare premiums or remain in a lower tax bracket, he can take distributions from his Roth 401(k). If he needs more taxable income, he can withdraw from his traditional 401(k). 

Conclusion

This strategy may not be the right choice for everyone. It is a good idea to discuss your personal situation with a financial planner and to discuss if or when implementing this may be a good choice. This article is provided for educational purposes only and shouldn’t be construed as individual financial or tax advice.