Seven thousand dollars. This is the maximum that individuals under age 50 can contribute to an individual retirement account. This is also the most that one would be able to deduct if eligible. That’s right. Deductibility is not a foregone conclusion. Business owners, on the other hand, have additional retirement options. Business owners can establish 401(k) plans, SIMPLE IRAs, and SEP IRAs to name a few. Contributions are also deductible. Traditionally, the decision was pretty straightforward. Contribute as much as possible into a retirement account, get a tax deduction, and pay taxes at a presumably lower rate when you retire. Enter 199A. Now, business owners may want to rethink their retirement contributions for maximum tax efficiency.
199A Overview
The Tax Cuts and Jobs Act created Code Section 199A to allow taxpayers other than a corporation to deduct the lesser of 20 percent of qualified business income plus 20 percent of REIT and publicly traded partnership income or 20 percent of taxable income minus the net capital gain. The deduction could be phased out by a taxpayer’s taxable income. Additionally, the deduction does not apply to Corporations or services provided as an employee. Qualified business income is essentially profit. As such, shareholder wages and partnership-guaranteed payments are specifically excluded from QBI. In other words, shareholder wages and guaranteed payments could potentially reduce qualified business income, in turn reducing the deduction. However, shareholder wages add to the W-2 wage base to calculate the QBI component for those with taxable income within the phase-out range.
QBI Income Production Strategy
As previously mentioned, the QBI deduction could potentially be limited by taxable income. While many taxpayers may not have to worry about this provision, there are a subset of people that should be aware.
While there may be other situations where taxpayers’ deductions could be limited, taxpayers with only Schedule C net income or partnership profit distributions will likely see their QBI deduction reduced by the taxable income limitation if they do not take proactive planning measures.
Example: Bob, a 40-year-old single taxpayer, only has $100,000 of QBI from a single-member LLC he owns. He has no other adjustments to income and takes the $12,400 standard deduction. Instead of taking a $20,000 QBI deduction ($100,000 QBI times 20 percent), Bob’s QBI deduction would be $17,520 ($100,000 QBI minus $12,400 standard deduction times 20 percent).
To take full advantage of this gift of a deduction, Bob could consider converting $12,400 of his Traditional IRA to a ROTH. This will increase his taxable income which will increase the QBI deduction, but it will also increase his overall tax burden by increasing his taxable income. However, implementing this strategy will allow Bob to pay taxes on 80 percent of the converted amount rather than paying taxes on 100 percent of a potentially larger amount in the future.
QBI Deduction Reduction
For those keeping score at home, deductible retirement contributions will decrease the QBI deduction for sole proprietors, single-member LLC disregarded entities, and partners taking distributive shares of profit. In addition to the taxable income limitation, there are a number of situations where the QBI deduction could be reduced. Bob’s deduction could be limited on two other unsuspecting retirement transactions.
Many taxpayers in Bob’s situation have been conditioned to put as much as possible into tax-deferred retirement accounts. As such, Bob decides to make a $20,000 SEP contribution due to its higher contribution limit and minimal administration costs. Since the contribution is considered an employer contribution, it directly lowers the qualified business income of the single-member LLC which reduces the deduction. Even though the deduction is lower, the overall current tax burden is lower due to the lower taxable income from making a large retirement contribution. As mentioned in the QBI Income Production strategy, however, forgoing tax deferral strategies will potentially allow taxpayers to pay taxes on 80 percent of profits today instead of paying taxes on 100 percent of a potentially larger retirement account distribution.
Armed with this new information, Bob decides to personally contribute $6,000 to a Traditional IRA to prevent a decrease in QBI. Unfortunately, this contribution still reduces Bob’s QBI deduction without reducing his QBI. This happens because the Traditional IRA deduction still reduces his taxable income and subjects him to the taxable income limitation. Bob may be better off making a ROTH IRA contribution.
Conclusion
While this post looked at just a few situations, there are a number of tax and nontax factors to consider with your own personal situation to determine your retirement contribution approach. This post is not advocating forgoing retirement contributions. Taxpayers should consult a qualified financial advisor or retirement expert about their retirement plan. This post is meant to solely consider the tax impacts of retirement account contributions. The takeaway should be that the traditional way of allocating retirement dollars should be reconsidered.
Disclosure
This article was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this article.
This is a hypothetical example and is not representative of any specific investment. Your results may vary.
Strategic Insights Financial Planning Group and LPL Financial do not provide tax advice or services. Please consult your tax advisor regarding your specific situation.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.