Previously I have blogged about small business retirement plans. This post (revised in January 2020) folds the new Section 199A qualified business income (“QBI”) deduction into the discussion.
For an introduction to Section 199A, please read this. For more on Section 199A, please read this additional post.
The Basics
Section 199A, enacted in December 2017 as part of tax reform, gives owners of businesses (including partners, owners of S corporations, and sole proprietors) that generate QBI a deduction in the amount of 20 percent of the QBI.
In January 2019, the IRS and Treasury issued regulations providing detailed rules under Section 199A. Those rules define QBI. As part of the definition of QBI, taxpayers must subtract contributions to self-employment retirement plans from QBI.
80% Deductions
When a self-employed individual contributes to a traditional retirement plan, they generally reduce the amount of their QBI deduction (because the retirement plan contribution lowers QBI).
Here’s a quick example (using 2018 tax numbers) of how that works.
Example: Mike makes $50,000 from his sole proprietorship (as reported on Schedule C). He pays $7,065 in self-employment tax (Social Security and Medicare). He deducts half of his self-employment tax ($3,533) from his taxable income and his QBI. Mike is married to Jane. Jane has $34,000 of W-2 wages. Mike and Jane file jointly and take the $24,000 standard deduction.
Mike thus receives a QBI deduction of $9,293 (20% of $46,467). This makes Mike and Jane’s taxable income $47,174 ($50,000 less $3,533 plus $34,000 less $24,000 less $9,293).
Let’s assume that Mike wants to make a $10,000 employee contribution to his Solo 401(k) to lower his taxable income by $10,000. Sure enough, the math does not work that way due to the QBI deduction. Mike’s QBI is now $36,467 (the original QBI of $46,467 less the $10,000 traditional Solo 401(k) contribution). Thus, his QBI deduction is now reduced to $7,293 (20% of $36,467). This makes Mike and Jane’s taxable income $39,174 ($50,000 less $3,533 plus $34,000 less $24,000 less $10,000 less $7,293).
Notice that $39,174 is $8,000 less than $47,174, not $10,000 less than $47,174. The interaction of Section 199A and the small business retirement plan creates the oddity that a $10,000 deduction (the traditional Solo 401(k) contribution) reduces taxable income by only $8,000.
QBI has thus created a new class of deductions – what I call “80% deductions.” These deductions reduce QBI and thus (in total effect) are deductible at only 80 percent of their gross amount.
As applied to small business retirement plans, 80% deductions are particularly troublesome. Recall Mike put $10,000 into his Solo 401(k), netting him an $8,000 federal tax deduction. When Mike goes to take the $10,000 (and its growth) out of the Solo 401(k), all of it will be taxable.
Matching 80% deductions with 100% inclusions is usually not smart tax planning.
I’ve written more about this phenomenon (what I call the Solo 401(k) Trap) here.
Planning Options
In cases where taxpayers are below the taxable income limitations of Section 199A ($163,300 and $326,600 (MFJ) for 2020), taxpayers will have to weigh the benefit of the 80 percent deduction for a traditional contribution to a small business retirement plan versus other options. Some of those other options include (if eligible):
- Make employee contributions to a Roth IRA, Roth Solo 401(k), and/or after-tax contributions to a Solo 401(k)
- Make contributions to a health savings account (a “HSA”)
- Make contributions to a traditional IRA
- Invest the earnings in taxable accounts and/or pay off existing debt.
Roth Contributions
Roth versus traditional receives much Internet discussion, particularly in the FI community. All agree that a taxpayer’s current marginal tax rate is vitally important. 80% deductions lower marginal tax rates. Take Mike, who with his retirement plan contributions lowered his 2018 taxable income to $39,174. As a married filing joint taxpayer, his marginal federal income tax rate is 12 percent. However, the marginal rate on the $10,000 retirement plan traditional contribution is only 9.6 percent (80 percent of 12 percent). In order for the traditional contribution to be advisable, Mike better be pretty sure he can pull the money out of the Solo 401(k) at a marginal federal tax rate below 9.6 percent. Being that the lowest marginal tax rate is 10 percent today, that does not seem very likely.
In Mike’s case, he would have been much better advised to leave his taxable income at $47,174 and made the Solo 401(k) contribution a Roth Solo 401(k) contribution.
HSAs/IRAs/Small Business Retirement Plans
Many small business owners are looking for current tax deductions, and many are in marginal tax brackets much above the 12 percent bracket. The interaction between Section 199A and small business retirement plans creates a new pecking order for self-employed individuals looking to reduce taxable income through plan contributions. That order is as follows:
- HSA Contributions (if eligible)
- Deductible Traditional IRA Contributions (if eligible)
- Traditional Small Business Retirement Plan Contributions
HSA Contributions
I’ve written about my fondness for HSAs here. What’s important for this purpose is that contributions to HSAs do not reduce QBI. Thus, contributions to HSAs are “100 percent deductions” and not 80% deductions. In addition to all their other advantageous tax attributes, HSA contributions should be prioritized over small business retirement plan traditional contributions from a Section 199A perspective.
Deductible Traditional IRA Contributions
Deductible contributions to traditional IRAs (for those who qualify) also should be prioritized over traditional contributions to small business plans from a Section 199A perspective.
In the previous version of this post, I expressed the concern that deductible traditional IRA contributions might reduce QBI. Fortunately, there is nothing the IRS and Treasury has provided (including the instructions to the new Form 8995) indicating that the government believes deductible traditional IRA contributions reduce QBI. Based on my understanding of the tax law, which has been reinforced by IRS and Treasury silence on the matter, I am comfortable that deductible traditional IRA contributions should not reduce QBI.
Taxable Accounts
There is no requirement to contribute to small business retirement plans. You can simply take profits and invest them in taxable accounts. Considering that traditional small business retirement plans contributions are now 80% deductions that must later create 100% income, you may opt to simply not make plan contributions and keep profits in taxable accounts. That may be very sensible if either or both the following are true: 1) you are currently in a very low marginal federal tax bracket and 2) you anticipate being in a much higher marginal federal tax bracket in the future.
S Corporation Owners
For S corporation owners, only the operating income after the owner’s W-2 salary is eligible for the Section 199A deduction. Small business retirement plan contributions are 80% deductions for the S corporation owner just as they are for the sole proprietor and for partners of partnerships with flow-through QBI.
Consideration should be given to employee versus employer contributions. To my mind, the new Section 199A deduction does not necessarily impact whether to make an employee contribution to a Solo 401(k) as a W-2 employee of your business. Yes, your salary is an 80% deduction. But what you from there with your salary (take it home, put it into a traditional Solo 401(k), or put it into a Roth Solo 401(k)) does not increase or decrease your qualified business income (though it could impact the taxable income limitations).
But an employer contribution to a Solo 401(k) (which must be a traditional contribution) does reduce your QBI. Employer contributions to Solo 401(k) plans often fall into the Solo 401(k) Trap.
In many cases, if you qualify for the QBI deduction you should give strong consideration to foregoing the employer contribution. Planning in this regard can benefit from professional consultations.
Your Employees
If you have employees, offering a SIMPLE IRA plan does not change the Section 199A result with respect to their salary. Normal operating expenses (including salaries) of QBI-generating businesses do create 80% deductions, but there is only so much that can be done about that. Unlike your own retirement plan contributions, which are (almost) entirely discretionary, operating expenses are necessary for the conduct of the business. Giving your employees the option of deferring some of their salaries through a SIMPLE IRA does not change the math on the Section 199A deduction, since employees’ salaries reduce QBI regardless of whether the employees contribute some of their salary to a SIMPLE IRA.
The relatively small mandatory employer contribution to employees’ SIMPLE IRAs are 80% deductions, making them a bit more expensive for the business owner (assuming the owner qualifies to claim the QBI deduction).
The Section 199A QBI deduction makes SEP IRA contributions more expensive for most self-employed business owners. In order to make contributions to his/her own SEP IRA, the owner must also make contributions (in an equal percentage of compensation) to the employees, and now those deductions are only 80% deductions (assuming the owner qualifies to claim the QBI deduction).
Upper Income Taxpayers
For some taxpayers, Section 199A will make their small business retirement plan contributions more, not less, valuable. In a previous post, I gave the example of Jackie, a sole proprietor lawyer whose 2020 taxable income (pre-retirement plan contributions) of $215,848 left him unable to claim any Section 199A QBI deduction. Maximum employer and employee traditional contributions of $57,000 to a Solo 401(k) lowered his taxable income such that he was able to qualify for a $31,770 QBI deduction (a 100% deduction) in addition to the $57,000 traditional retirement plan contribution deduction (an 80% deduction).
This interaction turned the $57,000 deduction into an effective $77,370 deduction (80 percent of $57,000 plus $31,770). In this case, Jackie’s retirement plan contributions are 136% deductions!
For upper income taxpayers near the QBI taxable income limitations, small business retirement plans may be a very powerful tool, and unlike those with more modest incomes, these upper income business owners may have an opportunity to maximize their Section 199A deduction by contributing to retirement plans.
Conclusion
The combination of Section 199A and small business retirement plans creates tax planning opportunities and challenges. Many small business owners will benefit from professional advice to determine the best path forward considering the new law, opportunities, and challenges.
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.