Aug. 21, 2019
The Tax Cuts and Jobs Act made a lot of changes in the realms of corporate, business, and individual federal taxes while leaving retirement planning taxes and laws relatively unchanged. But that does not mean retirement planning decisions and strategies are exactly the same as they were two years ago. Lower taxes for some could allow them to save more or consider other investment strategies.
With businesses, the TCJA created a significant tax deduction for pass-through business owners (including self-employed taxpayers who report their business activities on Schedule C) called the “199A deduction.” This deduction – perhaps one of the most complex in the TCJA – should modify how some business owners save for retirement. Let’s take a look at a few ways the 199A deduction changed the conversation around retirement savings.
1. Use Plan Deductible Contributions to Qualify for 199A
In order to qualify for the full 20 percent of qualified business income 199A deduction, the business owner needs to meet certain qualifications. The deduction can be completely lost or limited due to income limitations. For specified service businesses, like consultants and financial advisors, etc., the deduction can phased-out based on your taxable income and will be completely lost if your taxable income exceeds the upper end of the phase-out limitations. For non-specified service businesses, the deduction could still be lost due to a phase-in of a potential limitation based on taxable income.
The income-based limitations are as follows:
- Single individual
$157,500 to $207,500 (2018)
$160,700 to $210,700 (2019)
- Married Filing Jointly
$ 315,000 to $415,000 (2018)
$ 321,450 to $421,450 (2019)
So, if your taxable income exceeds the thresholds and your 199A deduction is limited or lost, one strategy to maximize the deduction is to bring taxable income down below the thresholds. One way to do this is to contribute to a retirement account. For instance, contributions to a 401(k), SEP IRA, SIMPLE IRA, deductible traditional, IRA, HSA, or defined benefit plan can be deductible from taxable income. This can allow you to save for retirement, lower your current tax bill, and qualify for the 199A deduction.
For example, let’s say you were a sole-proprietorship and did consulting, with a projected taxable income of $210,000 in 2018. At this level, you would be completely phased out of any 199A deduction as a specified-service business and single filer.
However, if you could drop your taxable income below the $157,500 limit, you could take a 20 percent deduction on all of your remaining qualified business income, which could lower your tax bill by thousands. If you had a solo 401(k), you could likely put away $54,000 by doing both employer and employee contributions, allowing you to drop below the phase-out limitation and get the full deduction on QBI.
If your income is well above the 199A thresholds, you could consider using a defined benefit plan for a larger deduction. In the right situation, you can set aside over $200,000 a year for retirement and deduct it from your taxable income by using a defined benefit plan. Still, this plan isn’t for everyone as it requires a lot of cash flow and funding.
In some cases, you can piece together multiple deductions to help lower your taxable income and save for retirement at the same time. For instance, you can max out your 401(k) and also use a defined benefit plan to save for retirement. Or you could use a SIMPLE or SEP and also contribute to an IRA to reduce your taxable income.
Furthermore, if you are in a high deductible plan, you could contribute up to $3,450 to an HSA for a single individual and $6,900 for a qualifying family in 2018.
Retirement plans offer a great way to set aside money for retirement and lower your tax bill today. But with 199A on the books, retirement savings could also help lower your taxable income, so you qualify for a larger 199A deduction.
2. Reduce Retirement Savings Contributions for Higher 199A deduction
Now if on the other hand, you don’t need to lower your taxable income to qualify for 199A, it is not always clear that saving for retirement in a deductible plan is the best strategy. Because deductible contributions to 401(k)s, SEPs, SIMPLEs, and defined benefit plans reduce taxable income, it can also reduce down qualified business income from a pass-through business and thereby actually reduce your 199A deduction.
So if you qualified for the full 199A deduction and saved $50,000 in your 401(k), you could be giving up a 20 percent deduction on that $50,000 of savings. In such a case, it might be better to consider not saving in the 401(k), having a higher qualified business income, and getting the 199A deduction.
Of course, you shouldn’t just stop saving for retirement altogether, so consider Roth tax savings opportunities in this case. Since the TCJA lowered tax rates for most people, it makes a lot of sense to use Roth savings for the next few years.
So, if your taxable income does not preclude you from the 199A deduction, take the deduction and put the money after-tax into a solo 401(k) Roth account or a Roth IRA (assuming you qualify based on Roth IRA contribution income limitations). Roth savings are after-tax, so they don’t help lower your current income, but as long as certain requirements are met, your investment gains come out tax-free in the future. If you can get a great deduction like the 199A today, it might make sense to do after-tax savings into a Roth account as opposed to pre-tax savings to a 401(k) or traditional IRA.
If you are reading this after year’s end but before tax time, all hope is not lost as some planning can still be done. You can still contribute to a traditional IRA for 2018, until you file your tax return, but no later than April 15, 2019. Furthermore, you can actually still set up a SEP IRA for 2018 until your tax return date plus extensions in 2019 and fund it for an individual with up to $55,000 for 2018. Traditional IRAs contributions max out at $6,000 ($7,000 if you are over age 50) for 2018. HSAs can also still be funded for 2018. There are a lot of strategies still on the table to help reduce down your taxable income before tax time.
Now if you are looking for Roth savings, you can still set up or fund a Roth IRA for 2018 until you file, but no later than April 15th, 2019. Roth IRA contributions do have income limitations so make sure you qualify before funding. However, with a 401(k), you cannot make new contributions to a Roth 401(k) account for 2018 at this point. However, you can always set up a new 401(k) for 2019 or amend an existing plan to add a Roth savings feature so you can use it moving forward.
The new 199A tax deduction created a lot of planning opportunities, but also a lot of complexity. While 199A wasn’t geared toward retirement savings decisions, its design has changed retirement savings considerations for small business owners.
If you don’t have a retirement plan in place, 199A planning (coupled with saving for retirement) might make you want to set one up as retirement plans can provide a lot of benefits to a small business owner both with savings opportunities and tax planning. For your specific situation make sure you look at all of your cash flow, retirement, business, and tax needs. Talk to a qualified professional to help you out.