After reviewing a 2018 tax return we’d just prepared, the client called and asked if it was still worth it for her to contribute to her simplified employee pension (SEP) for her small business. She saw that the more she contributed to her SEP, the lower her new qualified business income (QBI) deduction was.
QBI (also know as the Internal Revenue Code Section 199A deduction) made its debut on 2018 tax returns, confusing many clients, but also happily surprising many clients who qualified and saw that big deduction for the first time.
The QBI deduction, under new IRC Section 199A, was part of the Tax Cuts and Jobs Act (TCJA), effective from 2018 through 2025. The most important goal of the TCJA was to reduce the tax rates on C corporations (C corps) from 35% to 21% to make them more competitive in world markets. This reduction, however, put pass-through businesses at a disadvantage relative to
C corps. Thus, the 20% QBI deduction was added to the TCJA to give pass-through entities a comparable tax break.
Much has been written on the new deduction, but after seeing how it’s playing out on actual 2018 tax returns so far, it’s clear that there are still many open questions and planning issues. One of these issues is the effect of the deduction on retirement planning.
Background
Subject to certain limitations explained below, Section 199A allows pass-through businesses (including sole proprietorships) to deduct 20% of their business income subject to certain limitations. The deduction is claimed on the business owner’s individual tax return, based on qualifying information provided by the business entity, through K-1 forms.
The QBI deduction doesn’t reduce business income for self-employment or Medicare taxes. It’s only for income tax. The QBI deduction also doesn’t reduce adjusted gross income (AGI). Instead, it reduces taxable income. For example, the QBI deduction doesn’t reduce AGI for AGI-based taxes or phase-outs, such as taxation of Social Security benefits, additional Medicare surcharges, medical deductions and other tax benefits based on AGI.
Income Limitations
All business owners (including financial advisors) generally qualify for a full 20% deduction if their taxable income doesn’t exceed the following amounts:
2019. $321,400 for married couples filing a joint return (married joint) and $160,700 for single filers.
2018. $315,000 for married joint and $157,500 for single filers.
However, when taxable income rises above these threshold levels, two limitations apply: A W-2 wage/unadjusted basis immediately after acquisition (UBIA) and a specified service trade or business (SSTB) limitation are phased in over these ranges:
2019 QBI. $321,400 to $421,400 for married joint and $160,700 to $210,700 for single filers.
2018 QBI. $315,000 to $415,000 for married joint and $157,500 to $207,500 for single filers.
The W-2 wage/UBIA provision limits the Section 199A deduction to the greater of: (1) 50% of the W-2 wages paid, or (2) 25% of the W-2 wages paid plus 2.5% of the unadjusted basis of depreciable property (UBIA) held in the trade or business.
The SSTB limitation totally eliminates the deduction for certain service businesses when taxable income exceeds the end of the phase-out range. IRC Section 199A(d)(2) defines ineligible businesses as:
… any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.
Taxable Income Limitation
In addition, the Section 199A deduction can’t exceed 20% of taxable income over capital gains. That’s an important limitation affecting retirement planning, because contributions to a tax-deductible retirement plan reduce taxable income, possibly triggering application of the taxable income limitation.
Retirement Planning
The deduction for contributions to retirement plans, including larger deductions for defined benefit plans, could play a key role in keeping income below the applicable threshold amount for SSTBs or for businesses without sufficient W-2 wages and/or UBIA to qualify for the full QBI deduction. If a taxpayer’s taxable income is above the applicable threshold amount, a retirement plan contribution might increase the QBI deduction from zero to a very substantial amount.
Example 1: Beth is a single accountant with taxable income of $208,000 in 2018. Because accounting is an SSTB and Beth’s income exceeds the end of the phaseout range for a single taxpayer ($207,500), she receives no QBI deduction. Beth contributes $51,000 to a SEP, reducing her taxable income to $157,000 so neither the SSTB nor the W-2 wage/UBIA limitation applies. This gives her a QBI deduction of $31,400 (.2 x $157,000) instead of $0.
It seems counterintuitive, but increasing taxable income with a Roth individual retirement account conversion can increase the QBI deduction if QBI exceeds taxable income. The increased QBI deduction can then be used to reduce the tax rate on the Roth IRA conversion.
Example 2: Art is a married taxpayer filing jointly with QBI of $165,000 and no other income. Art is in the 22% marginal tax bracket for 2018. He claims the $24,000 standard deduction, reducing his taxable income to $141,000. Art’s QBI deduction is $28,200 (.2 x the lesser of QBI or taxable income). Art converts $24,000 of his traditional IRA to a Roth IRA, increasing his QBI deduction by $4,800 to $33,000. In effect, this increased deduction enables Art to reduce the tax rate on the Roth conversion from 22% to 17.6% (.8 x 22%).
But, there has to be a delicate balance here for SSTB clients and others who may face QBI deduction disqualification if income goes too high and exceeds the QBI threshold amounts.
Roth vs. Traditional IRA
The new Section 199A deduction also affects the Roth IRA versus traditional IRA contribution decision, making a Roth contribution somewhat more favorable relative to a contribution to a traditional IRA.
Example 3: Assume that in 2016, Helen is in the 30% marginal tax bracket and expects to be in the same 30% bracket when she receives distributions. She has $5,000 of income that she wants to contribute to either a traditional IRA or Roth IRA. Assume that the $5,000 will double in value by the time Helen retires. Everything else being equal, the after-tax amount available to Helen when she retires will be the same whether she makes the contribution to a traditional IRA or to a Roth IRA.
Traditional IRA
After-tax contribution $5,000
Value at retirement $10,000
Tax payable $3,000
After-tax value at retirement $7,000
Roth IRA
After-tax contribution $3,500
Value at retirement $7,000
Tax payable. $0
After-tax value at retirement $7,000
Example 4: Assume the same facts as in Example 3 except that the year is 2018, and Helen has QBI of $100,000. The $5,000 traditional IRA contribution reduces her QBI to $95,000 and her QBI deduction to $19,000. Thus, in effect, the traditional IRA deduction is only worth $4,000 instead of $5,000, leaving $300 of tax payable at the time of the contribution. The traditional IRA/Roth IRA comparison would then look like this:
Traditional IRA
After-tax contribution $4,700
Value at retirement $9,400
Tax payable $2,820
After-tax value at retirement $6,580
Roth IRA
After-tax contribution $3,500
Value at retirement $7,000
Tax payable $0
After-tax value at retirement $7,000
The 80% Deduction Issue
In January 2019, the Internal Revenue Service released final regulations affecting how the deduction will be calculated. The calculation of QBI starts with taxable business income, but that business income is further reduced by the deduction for one-half of the self-employment tax, the self-employed health insurance deduction and the deduction for retirement account contributions made by the business owner.1
For example, for partners and sole proprietors, the SEP deduction doesn’t reduce their business income at the entity level, but it does reduce business income for QBI deduction purposes, and that makes deductible retirement contributions for these entities less valuable. Thus, the SEP creates a QBI deduction reduction.
Example 5: Assume that Joe’s taxable income is below the QBI limits, and he qualifies for the full QBI deduction. Joe’s Schedule C Net Income (QBI) is $100,000. With no SEP deduction, Joe’s QBI deduction is $20,000 ($100,000 x 20%).
If Joe contributes, say, $15,000 to his SEP, his net business income for the QBI deduction will be $85,000, so his QBI deduction will be reduced to $17,000 ($85,000 x 20%).
QBI deduction before the SEP $20,000
Less: QBI deduction after the SEP (17,000)
Reduction of QBI deduction $3,000
Net effect:
SEP deduction $15,000
Less: QBI deduction reduction (3,000)
Net SEP deduction benefit $12,000
Total deductions:
Before the SEP $20,000 (the QBI
deduction only)
After the SEP $32,000 (the $15,000
SEP + the $17,000 QBI deduction)
Before contributing to the SEP, Joe’s deduction (the QBI deduction) was $20,000. When Joe made a SEP contribution of $15,000, his total deductions should have been increased to $35,000 ($20,000 + $15,000), but his net deduction won’t be the full $35,000. It will only be a net deduction benefit of $32,000 ($35,000 less the QBI deduction reduction of $3,000 = $32,000).
Joe increased his deductions by the $15,000 he contributed to his SEP, but he only receives a net benefit of 80% for his $15,000 SEP contribution ($15,000 x 80% = $12,000). Joe is an “80 percenter,” because he only receives 80% of the tax deduction benefit of his SEP contribution, but when he retires, he’ll include 100% of that money in income.
The negative impact of this QBI deduction reduction obviously increases as the tax rate increases. Those in higher brackets will lose more of the benefit of the SEP or other retirement contribution deduction.
Plan Roth contributions (for example, Roth 401(k) contributions) can be an alternative to making contributions to SEPs or other tax-deferred plans. Using the Roth 401(k), for example, can allow the full QBI deduction and remove the 80% problem, assuming of course that the loss of the tax deduction doesn’t put the client’s income over the QBI threshold amounts. With a Roth plan contribution, there’s no tax deduction, so there’s no reduction of the QBI deduction. Plus, the Roth account grows tax free, and there are no lifetime RMDs. That will keep his taxable income lower in retirement.
Let’s get back to our small business owner client. She decided to go with the maximum SEP contribution. So, back to her original question: Was it worth it to contribute to her SEP, knowing she isn’t receiving the full tax benefit? It was more important to her to keep building her retirement savings and not to be deterred by a lower QBI deduction. She believed the retirement contribution was of primary importance to build her retirement savings, and the QBI deduction, while fantastic, was just gravy—an extra benefit that was partially reduced. Other taxpayers might reach a different conclusion depending on their fact situation.
Factors to Evaluate
Here are factors that advisors can evaluate for business clients who must choose the right path to maximize their retirement savings and still benefit from the QBI deduction.
Retirement timeline. If the client is younger and has many more years until retirement funds must be withdrawn, then it’s probably still worth making the deductible retirement plan contribution now and for years to come so the retirement account can keep building. On the other hand, if the client is closer to retirement and will soon be withdrawing the funds, the tax inefficiency may not be worth it. However, if the client is contributing to a 401(k), it might still pay to contribute at least up to the company match, if available, to secure those funds.
Tax rates. If the client’s tax rate is higher now than it’s projected to be in retirement, then contributing to the retirement plan may be worth it, even for those who will only receive 80% of the benefit. It’s true that in retirement, 100% will be taxable, but possibly at a lower tax rate, and possibly many years out. However, advisors have to be careful about counting on tax rates being lower in retirement. Clients who are contributing and building tax-deferred retirement accounts will have higher taxable RMDs in retirement, increasing their income and possibly the tax rate they’re projecting. Also, future tax rates are likely to be higher given the government’s current deficit.
Qualifying for the QBI deduction. It may turn out that the client doesn’t qualify for the deduction due to income limitations or other qualifying factors. For example, if the client is an attorney with income over the threshold amounts, then the QBI deduction isn’t available anyway because this business activity is an SSTB. In this case, it pays to contribute to the retirement plan and get the full tax deduction benefit and at a higher tax rate (because being over the QBI income limits means the client is in a higher tax bracket). There would be no QBI deduction anyway, so it won’t be reduced by contributing to a retirement account. Even if the business isn’t an SSTB, the W-2 wage/UBIA limitation might reduce or eliminate the deduction.
Married Couple Planning Issues
If one spouse has income from an SSTB and can’t qualify for the QBI deduction because the other spouse’s taxable income puts them over the income limitation, then it might pay to contribute to the tax-deferred retirement account for the SSTB even if it would be only an 80% benefit. Lowering the income could allow the QBI deduction, giving them an overall tax savings.
Building Retirement Savings
Never underestimate the value of a healthy retirement account. Even if a deduction is only worth 80% due to the QBI deduction/retirement plan deduction interplay, in most cases it still pays to keep contributing and building retirement savings. That’s not a habit that should be broken merely because of a tax inefficiency. The life of the QBI deduction is temporary. Under the TCJA, it’s slated to be eliminated, along with many other tax provisions, after 2025. Is it wise to hold off on making retirement contributions until after 2025, due to the QBI deduction reduction? No, because that will leave clients with less saved for retirement. Advisors have to look to the best long-term outcomes when helping clients plan for their retirement years.
If the retirement contributions continue, clients will still end up with more retirement savings compounding tax deferred. That can’t be discounted. True, they may be slightly losing the tax rate arbitrage game, but in the long run, clients would still rather have more money put away for their retirement years. In addition, they may make up some of that tax rate differential by contributing in years when they’re at higher tax rates and withdrawing in retirement when tax rates could be lower. Also, even a lower current QBI deduction can be worth it if the deduction is taken in years when tax rates are higher.
Even if tax rates aren’t lower in retirement, RMDs will be taken in only small percentages each year, so clients could remain in a lower tax bracket, depending of course on other taxable income in retirement.
The point here is to bring this interplay of the QBI deduction and retirement plan contributions to the attention of clients and plan to maximize both when possible, while still keeping an eye on the big long-term goal of building tax-efficient retirement savings.
Endnote
1. Treasury Regulations Section 1.199A-3(b)(1)(vi).