Tag Archives: Small Business

2021 YEAR-END TAX PLANNING

It’s time to think about year-end tax planning. Year-end is a great time to get tax planning ducks in a row and take advantage of opportunities. This is particularly true for those in the financial independence community. FI principles often increase one’s tax planning opportunities.  

Remember, this post is for educational purposes only. None of it is advice directed towards any particular taxpayer. 

Backdoor Roth IRA Deadline 2021

As of now (December 7, 2021), the legal deadlines around Backdoor Roth IRAs have not changed: the nondeductible 2021 traditional IRA contribution must happen by April 18, 2022 and there is no legal deadline for the second step, the Roth conversion. However, from a planning perspective, the practical deadline to have both steps of a 2021 Backdoor Roth IRA completed is December 31, 2021. 

This is because of proposed legislation that eliminates the ability to convert nondeductible amounts in a traditional IRA effective January 1, 2022. As of December 7th, the proposed legislation has passed the House of Representatives but faces a very certain future in the Senate. Considering the risk that the Backdoor Roth elimination proposal is enacted, taxpayers planning on completing a 2021 Backdoor Roth IRA should act to ensure that the second step of the Backdoor Roth IRA (the Roth conversion) is completed before December 31st. 

Taxpayers on the Roth IRA MAGI Limit Borderline

In years prior to 2021, taxpayers unsure of whether their income would allow them to make a regular Roth IRA contribution could simply wait until tax return season to make the determination. At that point, they could either make the regular Roth IRA contribution for the prior year (if they qualified) or execute what I call a Split-Year Backdoor Roth IRA.  

With the proposed legislation looming, waiting is not a good option. The good news is that taxpayers executing a Backdoor Roth IRA during a year they actually qualify for a regular annual Roth IRA contribution suffer no material adverse tax consequences. Of course, in order for this to be true there must be zero balance, or at most a very small balance, in all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2021. 

December 31st and Backdoor Roth IRAs

December 31st is a crucial date for those doing the Roth conversion step of a Backdoor Roth IRA during the year. It is the deadline to move any balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs to workplace plans in order to ensure that the Roth conversion step of any Backdoor Roth IRA executed during the year is tax-efficient. 

This December 31st deadline applies regardless of the proposed legislation discussed above. 

IRAs and HSAs

Good news on regular traditional IRA contributions, Roth IRA contributions, and HSA contributions: they don’t have to be part of an end-of-2021 tax two-minute drill. The deadline for funding an HSA, a traditional IRA, and a Roth IRA for 2021 is April 18, 2022. 

Solo 401(k)

The self-employed should consider this one. Deadlines vary, but as a general rule, those eligible for a Solo 401(k) usually benefit from establishing one prior to year-end. The big takeaway should be this: if you are self-employed, your deadline to seriously consider a Solo 401(k) for 2021 is ASAP! Usually, such considerations benefit from professional assistance. 

Something to look forward to in 2022: my upcoming Solo 401(k) book!

Charitable Contributions

For those itemizing deductions in 2021 and either not itemizing in 2022 or in a lower marginal tax rate in 2022 than in 2021, it can be advantageous to accelerate charitable contributions late in the year. It can be as simple as a direct donation to a qualifying charity by December 31st. Or it could involve contributing to a donor advised fund by December 31st.  

A great donor advised fund planning technique is transferring appreciated securities (stocks, bonds, mutual funds, or ETFs) to a donor advised fund. Many donor advised fund providers accept securities. The tax benefits of making such a transfer usually include (a) eliminating the built-in capital gain from federal income taxation and (b) if you itemize, getting to take a current year deduction for the fair market value of the appreciated securities transferred to the donor advised fund. 

The elimination of the lurking capital gain makes appreciated securities a better asset to give to a donor advised fund than cash (from a tax perspective). Transfers of appreciated securities to 501(c)(3) charities can also have the same benefits.

The 2021 deadline for this sort of planning is December 31, 2021, though taxpayers may need to act much sooner to ensure the transfer occurs on time. This is particularly true if the securities are transferred from one financial institution to a donor advised fund at another financial institution. In these cases, the transfer may have to occur no later than mid-November, though deadlines will vary.

Early Retirement Tax Planning

For those in early retirement, the fourth quarter of the year is the time to do tax planning.  Failing to do so can leave a great opportunity on the table. 

Prior to taking Social Security, many early retirees have artificially low taxable income. Their only taxable income usually consists of interest, dividends, and capital gains. In today’s low-yield environment, without additional planning, early retirees’ taxable income can be very low (perhaps even below the standard deduction). 

Artificially low income gives early retirees runway to fill up lower tax brackets (think the 10 percent and 12 percent federal income tax brackets) with taxable income. Why pay more tax? The reason is simple: choose to pay tax when it is taxed at a low rate rather than defer it to a future when it might be taxable at a higher rate.

The two main levers in this regard are Roth conversions and tax gain harvesting. Roth conversions move amounts in traditional retirement accounts to Roth accounts via a taxable conversion. The idea is to pay tax at a very low tax rate while taxable income is artificially low, rather than leaving the money in deferred accounts to be taxed later in retirement at a higher rate under the required minimum distribution (“RMD”) rules. 

Tax gain harvesting is selling appreciated assets when one is in the 10 percent or 12 percent marginal tax bracket so as to incur a zero percent long term capital gains federal tax rate on the capital gain. 

Early retirees can do some of both. In terms of a tiebreaker, if everything else is equal, I prefer Roth conversions to tax gain harvesting, for two primary reasons. First, traditional retirement accounts are subject to ordinary income tax rates in the future, which are likely to be higher than preferred capital gains tax rates. Second, large taxable capital gains in taxable accounts can be washed away through the step-up in basis at death. The step-up in basis at death doesn’t exist for traditional retirement accounts. 

One time to favor tax gain harvesting over Roth conversions is when the traditional retirement accounts have the early retiree’s desired investment assets but the taxable brokerage account has positions that the early retiree does not like anymore (for example, a concentrated position in a single stock). Why not take advantage of tax gain harvesting to reallocate into preferred investments in a tax-efficient way?

Long story short: during the fourth quarter, early retirees should consider their taxable income for the year and consider year-end Roth conversions and/or tax gain harvesting. Planning in this regard should be executed no later than December 31st, and likely earlier to ensure proper execution. 

Roth Conversions, Tax Gain Harvesting, and Tax Loss Harvesting

Early retired or not, the deadline for 2021 Roth conversions, tax gain harvesting, and tax loss harvesting is December 31, 2021. Taxpayers should always consider timely implementation: these are not tactics best implemented on December 30th! 

For some who find their income dipped significantly in 2021 (perhaps due to a job loss), 2021 might be the year to convert some amounts in traditional retirement accounts to Roth retirement accounts. Some who are self-employed might want to consider end-of-year Roth conversions to maximize their qualified business income deduction. 

Stimulus and Child Tax Credit Planning

Taxpayers who did not receive their full 2021 stimulus may want to look into ways to reduce their 2021 adjusted gross income so as to qualify for additional stimulus funds. I wrote in detail about one such opportunity in an earlier blog post. Lowering adjusted gross income can also qualify taxpayers for additional child tax credits. 

There are many factors you and your advisor should consider in tax planning. This opportunity may be one of them. For example, taxpayers considering a Roth conversion at the end of the 2021 might want to hold off in order to qualify for additional stimulus and/or child tax credits. 

Accelerate Payments

The self-employed and other small business owners may want to review business expenses and pay off expenses before January 1st, especially if they anticipate their marginal tax rate will decrease in 2022. Depending on structure and accounting method, doing so may not only reduce income taxes, it could also reduce self-employment taxes. 

State Tax Planning

For my fellow Californians, the big one here is property taxes. It may be advantageous to pay billed (but not yet due) property taxes in late 2021. This allows taxpayers to deduct the amount on their 2021 California income tax return. In California, the standard deduction ($4,601 for single taxpayers, $9,202 for married filing joint taxpayers) is much lower than the federal standard deduction, so consideration should be given to accelerating itemized deductions in California, regardless of whether the taxpayer itemizes for federal income tax purposes.

Required Minimum Distributions (“RMDs”)

They’re back!!! RMDs are back for 2021. The deadline to withdraw a required minimum distribution for 2021 is December 31, 2021. Failure to do so can result in a 50 percent penalty. 

Required minimum distributions apply to most retirement accounts (Roth IRAs are an exception). They apply once the taxpayer turns 72. Also, many inherited retirement accounts (including Roth IRAs) are subject to RMDs, regardless of the beneficiary’s age. 

Planning for Traditional Retirement Accounts Inherited in 2020 and 2021

Those inheriting traditional retirement accounts in 2020 or later often need to do some tax planning. The end of the year is a good time to do that planning. Many traditional retirement account beneficiaries will need to empty the retirement account in 10 years (instead of being on an RMD schedule), and thus will need to plan out distributions over the 10 year time frame to manage taxes rate on the distributions.

2021 Federal Estimated Taxes

For those with small business income, side hustle income, significant investment income, and other income that is not subject to tax withholding, the deadline for 2021 4th quarter estimated tax payments to the IRS is January 18, 2022. Such individuals should also consider making timely estimated tax payments to cover any state income taxes. 

Review & Update Beneficiary Designation Forms

Beneficiary designation forms control the disposition of financial assets (such as retirement accounts and brokerage accounts) upon death. Year-end is a great time to make sure the relevant institutions have up-to-date forms on file. While beneficiary designations should be updated anytime there is a significant life event (such as a marriage or a death of a loved one), year-end is a great time to ensure that has happened. 

2022 and Beyond Tax Planning

The best tax planning is long term planning that considers the entire financial picture. There’s always the temptation to maximize deductions on the current year tax return. But the best planning considers your current financial situation and your future plans and strives to reduce total lifetime taxes. 2022 is as good a time as any to do long-term planning.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Qualified Business Income Deduction Update

For those interested in tax planning for the FI community, some interesting news came from the Senate this week. Senator Ron Wyden, a Democrat and the Chairman of the Senate Finance Committee, released a proposal to modify the Section 199A qualified business income (“QBI”) deduction.

My view is that this is very good news, for reasons I will discuss below.

QBI Deduction

The Section 199A QBI deduction provides small business owners a deduction of up to 20 percent of their “qualified business income.” Usually, this is income from self-employment (reported on Schedule C) or income from a partnership or S corporation (reported on Form K-1). The deduction is subject to a host of limitations which tend to kick in hard for upper income taxpayers. 

I’ve written plenty on the Section 199A QBI deduction. My introductory post is here, and a more advanced post is here. 

The QBI deduction is good for the financial independence community. It lowers the federal income tax burden on those with small businesses and side hustles. 

Expiration

But there is one lurking issue with the QBI deduction: will it last? There are two reasons to worry that it will not. First, it was enacted by Republicans in late 2017 in a polarized political environment. While that means Washington Republicans generally support the deduction, it also means Washington Democrats may have no particular political reason to support it. Second, the deduction has an expiration date: December 31, 2025: The deduction is not available in tax years beginning after that date. 

While there are few things more permanent than a temporary tax deduction, obviously it is worrisome that if nothing else happens, we only have four and a half more years of the tax deduction. 

Wyden Proposal

Senator Wyden introduced a proposal to modify the Section 199A QBI deduction. The legislative language is available here and a summary of the legislation from Senator Wyden’s staff is available here.

I am still reviewing the language, so at this point (July 21, 2021) I only have a basic understanding of it. Please take the below as a preliminary analysis subject to change. 

The bill keeps the QBI deduction, but appears to eliminate it entirely (as related to qualified business income itself) if taxable income reported on the tax return is $500,000 or more. Between $400K and $500K of taxable income, the QBI deduction is phased out. It appears single taxpayers do very well with this provision, as the limits apply per tax return, and are not doubled for married filing joint taxpayers. 

The Wyden proposal eliminates the ability for married filing separately taxpayers and estates and trusts to claim the QBI deduction. 

The bill also eliminates the concept of a “specified service trade or business.” This simplifies the QBI deduction and will help many self-employed professionals qualify for the deduction where under current law they would not. 

See the example of Jackie I posted here. Without a deduction for Solo 401(k) contributions Jackie did not qualify for any QBI deduction at all because he was a single lawyer with a taxable income over $215K. If the Wyden proposal is enacted as written, Jackie could have up to $400K in taxable income and claim a full QBI deduction. Single moderate to high income professionals appear, at first glance, to be the big winners if the Wyden proposal is enacted. Some married professionals will also benefit from this provision. 

Section 199A Dividends

The proposed bill appears to keep the 20 percent deduction for “Section 199A dividends” which are dividends paid by real estate investment trusts (“REITs”) and mutual funds and ETFs which own REITs. It appears, however, that a taxpayer’s ability to deduct Section 199A dividends would phase out between $400K and $500K of taxable income. Under current law there is no taxable income limit on the ability to deduct 20 percent of Section 199A dividends. 

Expiration 

The Wyden proposal does not eliminate the expiration date, December 31, 2025. To my mind, that is not too surprising. Eliminating the expiration date would increase the “cost” of the Wyden proposal and thus, under Congressional budgeting procedures, likely require cutting spending or raising other taxes. 

The Good News

To my mind, the Wyden proposal is good news for those fond of the QBI deduction. Instead of eliminating the QBI deduction, we now have a powerful Washington Democrat embracing large parts of the deduction, and expanding its availability for some taxpayers. If this were to pass (and that is very speculative), then both Republicans and Democrats would have passed a version of the QBI deduction. At that point, it is unlikely that either party would want to be responsible for the deduction dying in full in 2026. 

This legislative proposal is simply a first step: stay tuned for further developments. But for the FI community, I see a powerful Washington Democrat embracing a large portion of the QBI deduction to be a positive development. 

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

Sean on the How to Money Podcast

I recently discussed tax planning, financial independence, and entrepreneurship on the How to Money podcast. Please click the below link to listen. https://www.howtomoney.com/smart-tax-planning-moves-with-sean-mullaney/

FI Tax Guy can be your financial planner Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

From Tax Returns to Tax Planning

Many colloquially refer to the Winter and early Spring as “tax season.” To my mind, that is short sighted. Yes, for most the time from late January to mid-April are when their tax return is prepared and filed. But the most impactful tax work is not tax return preparation — it’s tax planning!

Below I discuss ways to use your current tax return as a springboard to tax planning. 

Before we get started, two notes. First, there is some tax planning that can be “do it yourself” and some tax planning that is best considered and implemented with the help of a tax planning professional. When in doubt, the concept is probably the latter. Second, it is helpful to keep in mind the correct use of this blog or any other blog–as a tool to raise awareness. Blogs are not a substitute for professional advice, and are not advice for any particular person. Rather, this post and others should be viewed as a way to increase knowledge and help faciliate more informed conversations with professionals. 

Your 2020 Tax Return

Your 2020 tax return is a great springboard for tax planning. Look at the following items on your tax return to jump start your tax planning.

Schedule D Line 13 Capital Gain Distributions

Everyone should review their own tax returns for the past few years and look at this line. If there is a substantial number on this line, it should raise a red flag.

I previously discussed capital gain distributions here. Generally, they come from mutual funds and ETFs in taxable accounts. These financial securities pass gains out to the shareholders, creating capital gains income on the shareholders’ tax returns. Actively managed funds tend to have much greater capital gain distributions than passively managed index funds.

The planning opportunity is to review the accounts that are generating significant capital gain distributions. If the realized gain in such accounts is low (or if there is a realized loss in those accounts), it might be advisable to sell the holding and replace it with a fund likely to have lower capital gain distributions. Taxpayers considering this strategy should be sure to fully understand the gain or loss in the securities before selling. Financial institutions do not have to report to investors (and the IRS) basis in mutual funds purchased prior to 2012, so sometimes it can be difficult to determine the taxable built-in gain or loss on older holdings.

Form 8889 Line 14c Distributions

Form 8889 is the tax return form for a FI favorite: the health savings account. Amounts other than $0 on Line 14c of Form 8889 should appear, in my opinion, only if the taxpayer is elderly or found themselves in a dire situation during the tax year. It is generally not optimal, from a tax perspective, to take distributions from an HSA to fund medical expenses when one is neither elder nor in a dire situation. 

Amounts other than $0 on Line 14c can be a learning and planning opportunity. Future routine medical expenses are usually best paid from one’s checking account (a regular taxable account), and taxpayers should save the receipt. In the future, taxpayers can reimburse themselves tax free from their HSA for that expense. In the meantime, the money has grown in the HSA and enjoyed many years of tax free compounding. 

Form 1040 Line 4b IRA Distributions Taxable Amount

Taxpayers who did a Backdoor Roth IRA and have a large amount on Line 4b of Form 1040 should review their transactions to make sure everything was correctly reported. Part of the idea behind a Backdoor Roth IRA is that, if properly executed, it should result in a very small amount of taxable income (as indicated on Line 4b). 

It may be the case that the tax return improperly reported the Backdoor Roth IRA (and thus, the taxpayer should amend their return to obtain a refund). Or, it may be the case that the taxpayer did the steps of the Backdoor Roth IRA at a time they probably should not have (because they had a significant balance in a traditional IRA, SEP IRA, or SIMPLE IRA). 

Discovering the problem can help effectively plan in the future, and if necessary take corrective action. 

For those executing Roth Conversion Ladders, a large amount on Line 4b is the equivalent of Homer Simpson’s Everything OK Alarm. Roth Conversion Ladders are intended to create a significant amount of taxable income, and Line 4b is where that income is reported on Form 1040. Note further that all Roth IRA conversions require the completion of Part II of the Form 8606. 

Schedule A Line 17 Total Deductions

Those who claimed itemized deductions in 2020 should review Line 17 of Schedule A. Is the number reported for the total itemized deductions close to the standard deduction amount (for 2021, single taxpayers have a standard deduction of $12,550 and married filing joint taxpayers have a standard deduction of $25,100)?

If so, there a tax planning opportunity. Why is that number what it is? Is it because of charitable contributions? If so, the donor advised fund might be a good opportunity. Here’s how it might work:

Example: Joe and Lisa file married filing joint. In 2020, they itemized based on $10K of state taxes, $9K of mortgage interest, and $6K of charitable contributions ($500 a month to their church). Thus, at $25,000 of itemized deductions, they were barely over the threshold to itemize. In 2021, they move a sizable amount into a donor advised fund ($25,000). They use the donor advised fund to fund their 2021, 2022, 2023, and 2024 monthly church donations. 

From a tax perspective, Joe and Lisa itemize in 2021 (claiming total deductions of $44K – the state taxes, mortgage interest, and a $25K upfront deduction for contribution to the donor advised fund). In 2022, 2023, and 2024, they would claim the standard deduction, which is (roughly speaking) almost equivalent to their 2020 itemized deductions. 

By using the donor advised fund, Joe and Lisa get essentially the same deduction in 2022 through 2024 that they would have received without the donor advised fund, and they get a tremendous one year increase in tax deductions in 2021. 

Form 8995 or Form 8995-A Line 2

Those with any amount on Line 2 of the Form 8995 or the Form 8995-A should likely consider some tax planning. This line indicates that the taxpayer has qualified trade or business income that may qualify for the new Section 199A qualified business income deduction. Taxpayers in this situation might want to consider consulting with a professional, as there are several planning opportunities available to potentially increase any otherwise limited Section 199A qualified business income deduction.

2021 Adjusted Gross Income Planning to Maximize Stimulus Payments

Taxpayers should review line 11 (adjusted gross income or “AGI”) on their Form 1040 in concert with reviewing their stimulus checks. For those taxpayers who did not receive their maximum potential stimulus payments in 2021, there can be opportunities to lower AGI so as to qualify for additional stimulus payments and/or increased child tax credits. I blogged about one planning opportunity in that regard here.

The Shift to Tax Planning

Tax planning can take many shapes and sizes. But it needs to be driven by goals, not by tactics. Bad tax planning begins something like this: “I need a Solo 401(k), how do I set it up?” N.B. Opening a Solo 401(k) when you do not qualify for one is a great way to create a tax problem for yourself. 

Good tax planning begins more like this: “I want to achieve financial independence. How do I best save for retirement in a tax advantaged way? I’ve heard a Solo 401(k) is a great option. As part of this process, we should consider it as a possible way to help me achieve my goal.”

Another point: I find there is far too much focus on “I had to pay [insert perceived sizable amount here] this year in taxes” and far too little focus on lifetime taxes. To my mind, the goal should not be to pay less tax in any one year. Rather, the goal should be to legitimately reduce lifetime tax burden. Sure, there can be tax planning that does both, but the best tax planning (whether DIY or with the help of a professional) places reducing lifetime tax burden as its primary goal.

Below are just some areas where taxpayers can begin their tax planning considerations.

Retirement Planning

This is a big one. Taxpayers should understand whether they contribute to a traditional IRA and/or Roth IRA, and why or why not. This post helps explain whether taxpayers qualify to make an annual contribution to a traditional IRA and/or a Roth IRA. 

Taxpayers should consider their workplace retirement plans, which can provide several planning opportunities. 

Small Business/Self-Employment Income

For those with a small business and/or significant self-employment income, tax planning is very important. I have written several posts about just some of the tax planning available to those with small businesses. People with small businesses often benefit from professional, holistic tax and financial planning. 

Stock Options

Stock options and employer stock grants provide some good tax planning opportunities. I’ve previously written about ISOs, but all kinds of stock option programs can be an opportunity to do some tax planning, which often should be with a professional advisor. 

Conclusion

Filing timely, accurate tax returns is important. But the best way to optimize one’s tax situation is to do quality, intentional tax planning. Tax planning should prioritize goals over tactics. There is some tax planning that can be done by yourself, but many areas of tax planning strongly benefit from professional assistance.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

Roth Conversions for the Self-Employed

Are you self-employed? Is your self-employment income your primary source of income? If so, you might want to consider doing a Roth conversion before the end of the year.

Takeaways

  • If most of your taxable income is self-employment income (either reported on Schedule C or from a partnership), you might want to consider year-end Roth conversions to maximize your QBI deduction and pay a lower-than-expected federal income tax rate on the conversion.
  • To optimize this strategy, convert traditional IRAs to Roth IRAs (or do in-plan traditional 401(k) to Roth 401(k) conversions) to increase your QBI deduction. 

Why? Because of the still relatively new qualified business income (“QBI”) deduction (also known as the Section 199A deduction). 

QBI Deduction and Initial Limitation

Starting in 2018, there is a deduction for “qualified business income.” This is generally income from a qualified trade or business received from a sole proprietorship (and reported on Schedule C), from a partnership, or from a S Corporation (in these cases, generally reported to the taxpayer on a Form K-1 and reported on the Schedule E with the tax return). 

Important for this purpose is the initial limit on the QBI deduction. It is the lesser of following two amounts:

  1. 20 percent of taxable income less “net capital gain” which is generally capital gains plus qualified dividend income (“QDI”) (the “Income Limit”) or
  2. 20 percent of QBI (the “QBI Limit”).

As a practical matter, in most cases the limit will be determined by the second limitation (such taxpayers are what I call “QBI Limited”). Many taxpayers will have much more taxable income than they have QBI. Consider spouses where one has self-employment income and the other has W-2 income. Unless the W-2 income is very small, their combined taxable income is likely to be in excess of their combined QBI, and thus they will be QBI Limited.

Alternatively, consider a situation where a single person has QBI from an S corporation (say $50,000) and the S corporation also pays him or her a W-2 salary (say $60,000). In such a case the QBI is $50,000 (20% of which is $10,000) and the taxable income might be $97,450 ($110,000 total from the S corporation less a $12,550 standard deduction), 20% of which is $19,490. This taxpayer would also be QBI Limited. 

Income Limited

But what if you are not QBI Limited, but rather, limited by the Income Limit listed above (what I call “Income Limited”)? Here is an illustrative example.

Example 1: Seth is single and self-employed. He claims the standard deduction in 2021. He reports a business profit of $100,000 on his Schedule C. He also has $1,000 of interest income.

His Income Limit is computed as follows:

Schedule C Income: $100,000

Interest Income: $1,000

Deduction for ½ Self-Employment Taxes: ($7,065)

Standard Deduction: ($12,550)

Taxable Income: $81,385

20% Limit: $16,277

Seth’s QBI Limit is computed as follows:

Schedule C Income: $100,000

Deduction for ½ Self-Employment Taxes: ($7,065)

QBI: $92,935

20% Limit: $18,587

In this case, Seth’s QBI deduction is only $16,277 (he is Income Limited), the lesser of these two calculated limits. 

Roth Conversion Planning

Is there anything Seth can do to increase his limitation and optimize his QBI deduction?

Imagine Seth has $20,000 in a traditional IRA (with zero basis). He could convert some of that traditional IRA to a Roth IRA by December 31, 2021. This would create taxable income, which would increase Seth’s Income Limit. Here is how that could play out:

Without Roth Conversion

Schedule C Income$ 100,000
Interest Income$ 1,000
Deduction for ½ Self-Employment Taxes$ (7,065)
Adjusted Gross Income$ 93,935
Standard Deduction$ (12,550)
Qualified Business Income Deduction (see above)$ (16,277)
Taxable Income$ 65,108
Federal Income Tax$ 10,072

With Roth Conversion

Schedule C Income$ 100,000
Interest Income$ 1,000
Deduction for ½ Self-Employment Taxes$ (7,065)
Roth IRA Conversion$ 11,550
Adjusted Gross Income$ 105,485
Standard Deduction$ (12,550)
Qualified Business Income Deduction$ (18,587)
Taxable Income$ 74,348
Federal Income Tax$ 12,105

What has the $11,550 Roth IRA conversion done? First, it has made the Income Limit ($18,587) the exact same as the QBI Limit ($18,587). Thus, Seth’s QBI deduction increases from $16,227 to $18,587. 

Second, notice that Seth’s taxable income has increased, but not by $11,550! Usually one would expect that a Roth IRA conversion with no basis recovery would simply increase taxable income by the amount converted. But not here! The interaction with the QBI deduction caused Seth’s taxable income to increase only $9,240 ($74,348 minus $65,108). 

This example illustrates that, under the right circumstances, a Roth IRA conversion can receive the benefit of the QBI deduction!

As a result, at Seth’s 22 percent marginal federal income tax bracket, his total federal income tax increased only $2,033. In effect, Seth pays only a 17.6 percent rate on his Roth IRA conversion ($2,033 of federal income tax on a $11,550 Roth IRA conversion). This is true even though Seth is in the 22 percent marginal tax bracket. His Roth IRA conversion is only 80 percent taxable. This is the flip-side of the 80% deduction phenomenon I previously blogged about here. 

Is it advantageous for Seth to convert his traditional IRA? Well, it depends on Seth’s expected future tax rates. If Seth’s future marginal tax bracket is anticipated to be 22 percent, then absolutely. Why not convert at a 17.6 percent instead of face a 22 percent rate on future traditional IRA withdrawals?

Strategy

Seth’s Roth IRA conversion is optimized. The takeaway is that the Roth IRA conversion gets the benefit of the QBI deduction, but only for amounts that increase the Income Limit up to the QBI Limit.

A *very general* rule of thumb for solving for the optimal Roth conversion amount is to multiply the difference between the QBI Limit and the Income Limit (without a Roth conversion) by 5. In Seth’s case, that was $18,587 minus $16,277 (which equals $2,310) times 5.

In this case, converting exactly $11,550 made Seth’s Income Limit exactly equal his QBI Limit. As long as the Roth conversion increases the Income Limit toward the QBI Limit, the conversion benefits from the QBI deduction.

But the first dollar of the Roth conversion that pushes the Income Limit above the QBI Limit does not receive the benefit. If Seth converted $11,551 from his traditional IRA to his Roth IRA, that last dollar above $11,550 would be taxed at Seth’s full 22 percent federal marginal tax bracket. 

Note that instead of / in addition to a Roth IRA conversion, Seth could do an in-plan traditional 401(k) to Roth 401(k) conversion, if he had sufficient funds in a traditional 401(k), and the 401(k) plan permits Roth 401(k) conversions.

Also note that the strategic considerations with QBI deductions become much more complicated once taxpayers exceed the initial QBI taxable income limitations (in 2021, those are $164,900 for single taxpayers and $329,800 for married filing joint taxpayers). 

Conclusion

Taxpayers whose taxable income consists mostly or exclusively of self-employment income should consider Roth conversions toward year-end. This is often an area that benefits from consulting with a professional tax advisor before taking action.

Further Reading

I have blogged about the QBI deduction and retirement plans here. After the IRS and Treasury provided some QBI deduction regulations in January 2019, I provided some QBI deduction examples and lessons here. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

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. Please also refer to the Disclaimer & Warning section found here. 

SEP IRA Versus Solo 401(k)

If you qualify for both a SEP IRA and a Solo 401(k), is there a clear winner? In the past, it was often the case that the tax benefits of a SEP IRA and a Solo 401(k) were similar, particularly if you also had access to a 401(k) plan at a full-time employer. Today the landscape has changed, and in most cases, there’s a clear winner.

This post discusses whether a SEP IRA or a Solo 401(k) is better in situations where the self-employed person qualifies for both plans.

Note that both plans have eligibility requirements. For example, under the tax rules, if you employ anyone other than your spouse for 1,000 hours or more during the year you are ineligible for a Solo 401(k). There are additional tax rules and separate (and additional) plan rules to consider to determine if you are eligible for a particular SEP IRA and/or Solo 401(k).

The Basics

Both the SEP IRA and the Solo 401(k) are self-employed retirement plans. They can be established by legal entities (in this context, often S corporations) or they can be established by individuals that have self-employed income. That self-employment income generally must come through a sole proprietorship or through a limited liability company (“LLC”) that is disregarded for tax purposes and reported on a Schedule C filed with the individual’s tax return. 

SEP IRAs

A SEP IRA allows only “employer” contributions. For this purpose, your own sole proprietorship or disregarded LLC can be your employer. 

Generally, the employer can make annual contributions of up to 25 percent of eligible W-2 compensation (from a corporation) or 20 percent of an individual’s self-employment income, limited to $66,000 of contributions in 2023.

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost SEP IRA options.  

A SEP IRA can be established for a tax year by the deadline for filing that tax year’s tax return, including extensions. 

The administrative compliance burden of a SEP IRA is generally very manageable. 

History of the SEP IRA vs. the Solo 401(k)

Watch me discuss the history of both the SEP IRA and the Solo 401(k).

Solo 401(k)s

A Solo 401(k) (sometimes referred to as an “Individual 401(k)”) is a 401(k) plan established by a self-employed individual for their own benefit. 

The main advantage of the Solo 401(k) is that it allows annual contributions by the self-employed individual in his/her role as the “employee” and annual contributions by the self-employed individual (or S corporation) in his/her role as “employer.” 

Employee contributions are limited to the lesser of earned income or $22,500 ($30,000 if 50 or older) in 2023. Employer contributions are limited to up to 25 percent of eligible W-2 compensation (from a corporation) or 20 percent of an individual’s self-employment income, limited to $66,000 of contributions in 2023. Total employee and employer contributions are limited to $66,000 ($73,500 if age 50 or above) in 2022. 

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost Solo 401(k) options.

The administrative compliance burden of a Solo 401(k) is generally very manageable, but note that once there are more than $250,000 in the plan and/or the plan is closed, a Form 5500-EZ must be filed.

The Clear Winner

At this point, you might be saying, “Great, both the SEP IRA and Solo 401(k) are attractive. Is there really a big difference between them? Should I care too much about which plan I establish?”

The answer is that in most cases, the Solo 401(k) is the much better option for a self-employed person. If you are considering a SEP IRA over a Solo 401(k) in a situation where you qualify for both, you ought to think twice about that decision.

Here are the main reasons why the Solo 401(k) is much better than the SEP IRA in most cases.

Employee Contributions

The Solo 401(k) allows employee contributions. If your self-employment income is relatively modest, this greatly increases the amount you could contribute. For example, if Jane, under age 50, has a side-hustle that earns her $10,000 in 2023 after the deduction for one-half of self-employment taxes is accounted for, her maximum Solo 401(k) contribution is $10,000, while her maximum SEP IRA contribution is only $2,000 (20% of $10,000).

Note that this assumes that Jane has contributed $12,500 or less to a workplace 401(k) or similar retirement plan. Using the 2023 limitations, $22,500 is the maximum total employee deferrals Jane can make to her 401(k) and similar plans, so Jane’s other employer retirement accounts should also be considered.

Section 199A and 80% Deductions

I have previously written about the new Section 199A qualified business income (“QBI”) deduction and its impact on self-employed retirement plans. Traditional contributions to both Solo 401(k) plans and SEP IRAs create, for many taxpayers, deductions that are only “80% deductions.” Here is an example.

After self-employment taxes, Joe, a single taxpayer, earns $120,000 from his sole-proprietorship. Joe makes a 10 percent employer contribution ($12,000) to either his Solo 401(k) or SEP IRA. In the 24 percent marginal tax bracket, he expects to save $2,880 ($12,000 times 24%) on his federal income taxes. He is surprised to learn that he only saved $2,304 on his federal income taxes. 

How is that possible? While Joe is correct that he receives a $12,000 retirement plan contribution tax deduction, he failed to consider that he lost $2,400 of his QBI deduction. A traditional Solo 401(k) contribution and a SEP IRA contribution is an 80% deduction. In Joe’s case, he received a net federal income tax deduction of only $9,600 (80 percent of $12,000). 

Why then would Joe prefer a Solo 401(k) to a SEP IRA? Because the Solo 401(k) gives him a planning option that avoid the 80% deduction issue. Instead of making traditional contributions to a Solo 401(k), Joe can make Roth employee contributions to a Solo 401(k).

Note further that Joe could possibly implement Mega Backdoor Roth IRA planning by making after-tax contributions to his Solo 401(k). Many Solo 401(k) plans do not offer this option, but some do.

The SEP IRA does not offer these options. 

Not all financial institutions offer the Roth Solo 401(k) and the after-tax Solo 401(k) contribution options. It is important to understand the features of any particular Solo 401(k) before you adopt it as your plan. 

For upper income taxpayers, the 80% deduction phenomenon may not be an issue, considering that the ability to claim the QBI deduction is reduced or eliminated above certain income thresholds. These taxpayers need not prefer the Solo 401(k) to a SEP IRA for QBI deduction reasons, but may prefer to have the increased planning ability, such as the ability to make Roth and/or after tax contributions to the Solo 401(k) that a SEP IRA does not offer. They may also prefer the Solo 401(k) for the reasons discussed below.

Backdoor Roth IRA Planning

The Backdoor Roth IRA is a great planning tool. But the Pro-Rata Rule can cause significant snags. For example, if you execute the two independent steps of a $6,500 Backdoor Roth IRA in a year when you have a separate significant traditional IRA, SEP IRA, or SIMPLE IRA at year-end, you will cause most of the Backdoor Roth IRA to be taxable. 

The SEP IRA is a significant roadblock to the ability to execute an efficient Backdoor Roth IRA. A Solo 401(k) does not cause this problem with the Backdoor Roth IRA. For this reason alone many will want to choose a Solo 401(k) instead of a SEP IRA, even if they plan on making traditional deductible contributions to the plan. 

Catch Up Contributions

If you are age 50 or older, you can make up to $7,500 (in 2022) in catch up employee contributions to a Solo 401(k).

This option does not exist for a SEP IRA. Thus, for high earning self-employed persons age 50 or older, a Solo 401(k) has an additional advantage over the SEP IRA.

Solo 401(k) Book

This post was originally published in 2019. In 2022 I published Solo 401(k): The Solopreneur’s Retirement Account, a book that goes into much more depth about Solo 401(k)s.

Conclusion

If you qualify for both, generally the Solo 401(k) is better than a SEP IRA. If you are going with a SEP IRA over a Solo 401(k), you should understand the reasons for doing so. Finally, self-employed retirement plans is an area that taxpayers usually benefit from receiving personal advice from a qualified tax advisor. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

Section 199A and Retirement Plans

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):

  1. Make employee contributions to a Roth IRA, Roth Solo 401(k), and/or after-tax contributions to a Solo 401(k)
  2. Make contributions to a health savings account (a “HSA”)
  3. Make contributions to a traditional IRA
  4. 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:

  1. HSA Contributions (if eligible)
  2. Deductible Traditional IRA Contributions (if eligible)
  3. 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.

FI Tax Guy can be your financial advisor! FI Tax Guy can prepare your tax return! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

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.

Small Business Retirement Plans

If you are self-employed or have a side hustle, you have great opportunities for tax-advantaged savings. Small business retirement planning has been an area of significant confusion due to the multitude of plans available and the different qualification rules for each.

Below I describe the three most important plans for most small businesses to consider, provide the qualification requirements, and discuss when each plan is the best option.

Fortunately, for roughly 90 percent of small businesses, there are only three options worth considering: the Solo 401(k), the SIMPLE IRA, and the SEP IRA. In many cases, one of the three options quickly becomes the advantageous option.

After I discuss the three main small business retirement plans, I will provide some commentary on other available plans, but for most small businesses, the playbook consists of these three plans.

The administrative burdens (forms, paperwork, fees to financial institutions) of all three of these programs are relatively light these days, though all three plans do have some forms that must be properly completed, signed, and filed.

Before we begin, three quick notes. First, on limitations. Below I provide (in a general sense) the upper annual limits on contributions to the plans. It is important to note that contributions can be made in a manner below the limits – the plans are flexible in this regard. Second, generally you can contribute to a small business retirement plan and to a Roth and/or traditional IRA. Having access to a small business retirement plan does not prohibit a contribution to a Roth IRA or a traditional IRA. Third, before implementing a plan it is best to discuss your business and needs with the plan provider. Providers can have rules that are different from (and/or in addition to) the applicable tax rules.

Solo 401(k)

The Basics: A Solo 401(k) (sometimes referred to as an “Individual 401(k)”) is a 401(k) plan established by a self-employed individual for only their own benefit. Solo 401(k)s can be established by self-employed individuals in their own name and by corporations (usually S corporations in this context). Self-employment for this purpose includes a sole proprietorship, limited liability company (“LLC”), or other entity treated as disregarded from their single owner and reported on a Schedule C on their tax return.

The main advantage of the Solo 401(k) is that it allows annual contributions by the self-employed individual in his/her role as the “employee” and annual contributions by the self-employed individual (or S corporation) in his/her role as “employer.”

Employee contributions are limited to the lesser of earned income or $19,500 ($26,000 if 50 or older) in 2020. Employer contributions are limited to either 20 percent of self-employment income or 25 percent of W-2 wages (if the self-employed individual is paid through a corporation, including S corporations). Total employee and employer contributions are limited to $57,000 ($63,500 if age 50 or above) in 2020.

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost Solo 401(k) options.

If eligible, the Solo 401(k) is almost always the best option for the self-employed individual. It offers the greatest potential for tax savings of the self-employed plans and it is relatively easy to administer.

An important note on the Solo 401(k) vis-a-vis the SIMPLE IRA and the SEP IRA: the Solo 401(k) is the only small business plan that allows Roth “employee” contributions. This allows self-employed individuals the ability to put away up to $19,500 ($26,000 if 50 or older) annually that will grow tax free. For all three plans, the “employer” contribution is always a traditional contribution (i.e., tax deductible today, taxable upon withdrawal). Note, however, that not all financial institutions offer the Roth employee contribution option in their Solo 401(k) plan, so it is important to check with the provider before signing up if the ability to make a Roth contribution is important to you.

Spouses employed by the self-employed individual (or their corporation) can also participate in the Solo 401(k) (only to the extent of their earnings from the business and subject to the above stated limitations), increasing the tax benefits of the plan.

Eligibility: In order to establish a Solo 401(k) plan, a person must have self-employment income, and must not have employees other than their spouse. For this purpose, an employee is anyone who works 1,000 hours during the year for the business. Starting in 2024, an employee also includes anyone who has worked 500 hours in each of 3 consecutive years.

Different plans have different rules on other employees. Some Solo 401(k) plans do not allow you to have any non-owner/non-spousal employees (regardless of the numbers of hours worked).

To have a Solo 401(k) in any tax year, the plan must be established by the deadline for the tax return, including extensions. That deadline also applies to employer contributions.

Generally, employee deferrals to a Solo 401(k) must be made by the end of the calendar year. There is an exception: if the Solo 401(k) is for a self-employed person (reporting self-employment income on Schedule C), the employee deferral must be formally designated by year-end, but then can be paid into the Solo 401(k) before the tax filing deadline (including extensions if the taxpayer extends his/her Form 1040).

Ideal for: Solo 401(k)s are ideal for anyone who is self-employed and does not have employees (other than a spouse).

SIMPLE IRA

The Basics: The SIMPLE IRA works in a manner somewhat similar to a 401(k) plan. It allows employees (including self-employed owners of the business) to defer up to $13,500 ($16,500 if 50 or older) of earnings in 2020 through traditional employee contributions. The SIMPLE IRA also has relatively modest required employer contributions to each eligible employee’s account (described below).

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost SIMPLE IRA options.  

In order to have a SIMPLE IRA for the year, the employer must establish the SIMPLE IRA by October 1st of the year. One narrow exception is when the business is established after October 1st, in which case the plan must be established when administratively feasible.

The SIMPLE IRA has two main advantages over the SEP IRA. First, it gives the self-employed owner and any employees a valuable option – the option to make traditional contributions to the SIMPLE IRA account. By contrast, the SEP IRA (discussed below) does not allow for employee contributions. Second, the required employer contribution is relatively low. Employers must make either matching contributions of 3 percent of salary (in 2 out of every 5 years that percentage can be reduced to 1 percent) or automatic annual contributions of 2 percent of salary to each employee’s SIMPLE IRA. Thus, the SIMPLE IRA can give the self-employed owner(s) the option to defer up to $13,500 ($16,500 if 50 or over) of earnings in a relatively affordable manner.

Eligibility: In order to be eligible for a SIMPLE IRA, the employer must have no other retirement plan and must have 100 or fewer employers during the year.

Ideal for: Self-employed individuals that are not eligible for a Solo 401(k) and are looking to provide themselves and their employees the option to defer some taxable income at a relatively low cost to the employer. Partnerships where two or more owners (non-spouses) work in the business and/or small businesses with employees are good candidates for a SIMPLE IRA.

SEP IRA

The Basics: A SEP IRA is allows only employer contributions. Generally, the employer can make annual contributions of up to 25 percent of eligible compensation (20 percent of a sole proprietor’s self-employment income), limited to $57,000 of contributions (in 2020).

Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost SEP IRA options.  

The SEP IRA has two important advantages. First, it allows the employer to elect each year whether to make contributions. The employer can elect to forego contributions or reduce the contribution each year. Second, the SEP IRA has the latest deadlines of all the plans. A SEP IRA can be established for a tax year by the deadline for filing that tax year’s tax return, including extensions.

The main disadvantage of a SEP IRA is that it generally requires equal percentage contributions to all eligible employees. Said differently, in order for the self-employed owner of the business to make an employer contribution to his/her own account, the business must make the same percentage contribution to all eligible employees. This makes the SEP IRA an expensive way to save for your own retirement if you are self-employed and have employees. SEP IRAs are also subject to “top heavy” rules whereby the employer may be required to put in additional contributions to the rank-and-file employees’ SEP IRAs if the owners’ and executives’ SEP IRA balances are too high vis-a-vis the rest of the employees’ SEP IRA balances.

Eligibility: An employer (a sole proprietor, partnership, or corporation, including S corporations) can establish a SEP IRA program. Employees that are 21 years old, earn $600, and have worked for three of the previous five years for the employer must be allowed to participate.

Ideal for: There are three situations in which a SEP IRA can be highly advantageous. The first is for a side hustlers that maximize their 401(k)/403(b)/TSP contributions to their W-2 employer’s plan. The SEP IRA provides a mechanism for these side hustlers to defer more income. Note, however, that this can also be accomplished through a Solo 401(k), and in most cases the Solo 401(k) is preferable to the SEP IRA (if a taxpayer is eligible for both).

The second situation is when a self-employed person has not established a self-employed retirement plan by year-end. In such cases, the taxpayer can establish and fund a SEP IRA for the prior year before their tax return deadline (including extensions).

Third, a SEP IRA can be helpful in situations where a small business has a small number of employees, all or most of which are very important to the business. The SEP IRA provides a way to give highly valued employees a significant benefit.

Side Hustlers

For most side hustlers, the question becomes: are you covered by a retirement plan (such as a 401(k)) at your W-2 job? If you are not, the Solo 401(k) in most instances is likely your best option.

If you are covered by a workplace retirement plan, such as a 401(k), then the SEP IRA may be your best option, since you can defer up to the lesser of 20 percent of your side-hustle income or $57,000 (in 2020) while you can take advantage of your $19,500 ($26,000 if 50 or older) employee contributions through your workplace plan. While the “employer” contribution calculation is the same for a SEP IRA and a Solo 401(k), the administrative cost of the SEP IRA (including IRS filings) tends to be lighter than that of the Solo 401(k).

In some situations, side hustlers might want to forego a SEP IRA and use a Solo 401(k) (instead of a workplace 401(k)) for some or all of their annual employee contributions. That would be true if you want to make Roth employee contributions and your workplace plan does not allow them and/or you believe the investment options in your Solo 401(k) plan are better than the options in your employer’s plan. However, in all cases consideration should also be given to ensuring you at least get the full match in your employer’s 401(k) plan.

One important consideration for side hustlers and all self-employed individuals is what I call the Solo 401(k) Trap. Because of the new Section 199A deduction, many will want to forego deducting retirement plan contributions to self-employment retirement accounts (i.e., traditional employee contributions to Solo 401(k)s and employer contributions to Solo 401(k)s and SEP IRAs) and instead make Roth employee contributions to Solo 401(k)s.

Note that there is no benefit to having both a Solo 401(k) and a SEP IRA for your side hustle, because contributions to both plans count against the relevant limitations (i.e., having two separate plans does not increase a taxpayer’s contribution limitations).

Other Plans

There are other options available to small businesses. All (with the exception of the SIMPLE 401(k)) of them involve significantly more administrative burden and costs than the Solo 401(k), the SIMPLE IRA, and the SEP IRA. Often these plans are not feasible for small businesses and these plans are rarely feasible for side hustlers.

SIMPLE 401(k)s

SIMPLE 401(k)s are very similar to SIMPLE IRAs, with some differences on the margins not worth mentioning here. Most financial institutions offer SIMPLE IRAs instead of SIMPLE 401(k)s.

Keoghs

Keoghs come in both defined contribution and defined benefit (i.e., pension) models. Keoghs involve significant additional administrative burdens when compared to Solo 401(k)s, SIMPLE IRAs, and SEP IRAs.

401(k)s

There is nothing stopping a small business from establishing a 401(k) plan just like the largest employers. However, as a practical matter, it is difficult for most small businesses to do so. First, they involve significant set-up and maintenance costs. Second, 401(k)s are subject to discrimination testing to prevent business owners and high compensated employees from enjoying the benefits of the plan to a much greater degree than rank-and-file employees. This testing can lead to either reversals of previous contributions to the plan or additional employer contributions to rank-and-file employees.

Defined Benefit Pension Plans

A defined benefit plan (where the employee receives a stated benefit during retirement years and the employer funds the plan during the employee’s working years) is another option. These plans require significant compliance costs, including actuarial calculations. Further, if you have employees, these plans can be quite expensive for the self-employed business owner. In addition, these plans often work against the financial independence model in that they tie up assets until the account owner reaches a certain retirement age. However, given the right set of circumstances (usually older, highly compensated earners), these plans can be advantageous and create large current tax deductions.

Conclusion

Small businesses have a great opportunity to create tax advantaged retirement savings. For those eligible for a Solo 401(k), in most cases significant consideration should be given to establishing one. Depending on your circumstances, the SIMPLE IRA or the SEP IRA might be a great solution.

My hope is that this post has given you some working knowledge of the three main options for small businesses. Small business owners will often benefit from obtaining professional advice regarding their retirement planning and the programs they ought to establish.

Next Week

Next week’s post (click here) explores small business retirement plans in light of the new Section 199A qualified business income deduction and how the two concepts interact.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

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.


Section 199A Examples and Lessons

Introduction

As this is being re-published (January 2021), we are in the third filing season of the new Section 199A qualified business income deduction. It is an area of the tax law that practitioners are still digesting.

I have previously written on the basics of the Section 199A deduction. This post builds on that introductory post. It provides analysis on rules from the IRS and Treasury and gives examples of how the deduction works in specific situations.

Takeaways

  • Deductions such as the deduction for one-half of self-employment taxes paid and the deduction for self-employed retirement plan contributions reduce the qualified business income (“QBI”) qualifying for the Section 199A deduction.
  • In many cases, Section 199A reduces the tax savings on traditional retirement plan contributions. Taxpayers may want to consider Roth employee contributions instead of traditional employee contributions to retirement plans because of this change.
  • Some taxpayers may want to prioritize contributions to traditional IRAs and HSAs instead of contributions to self-employed and small business retirement plans to maximize their Section 199A deduction.
  • Potentially powerful tax planning opportunities exist whereby taxpayers can reduce their taxable incomes such that they can go from no Section 199A deduction to a significant deduction. See Managing Taxable Income below for one example.
  • Many small businesses (including many sole proprietorships and S corporations) should not make charitable contributions, since these reduce qualified business income deduction. Rather, the owners of these small businesses should make charitable contributions in their own names.
  • The IRS and Treasury have provided a safe harbor under which rental real estate activities can qualify for the Section 199A deduction.
  • Dividends received from mutual funds and ETFs investing in domestic REITs can qualify for the Section 199A deduction.

Below are examples and commentary addressing Section 199A.

Side Hustler

Mike works a full-time job. His W-2 for 2018 reports $90,000 of wages. Mike also receives $1,000 of qualified dividend income (“QDI”) in his taxable account. Mike has a side hustle where he nets $10,000 in Schedule C profit. Mike pays $1,413 in self-employment tax on that profit. Mike claims the standard deduction.

Recall that the Section 199A deduction is the lesser of:

  1. 20 percent of your taxable income less your “net capital gain” which is generally your capital gains plus your QDI; or,
  2. 20 percent of your qualified business income (“QBI”).

The deduction for one-half of self-employment taxes is factored into the determination of QBI. Thus, in Mike’s case, his Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($90,000 plus $10,000 plus $1,000 less $707 less $1,000 less $12,000 = $87,293) = $17,459; or,
  • 20% of QBI: 20% times ($10,000 less $707 = $9,293) = $1,859

In this case, Mike’s Section 199A deduction is $1,859.

Mike’s taxable income is determined by deducting, for adjusted gross income, one-half of the self-employment taxes ($707) he pays with respect to his side hustle income. However, that deduction for half of his self-employment tax must also be subtracted in determining his QBI.

Note further that the Section 199A deduction does not reduce self-employment taxes. The Section 199A deduction is only an income tax deduction. It does not reduce the amount subject to self-employment taxes (in Mike’s case, $10,000).

Sole Proprietor with a Solo 401(k)

Lisa owns a sole-proprietorship that generates $100,000 of business income in 2020 as reported on Schedule C. Lisa pays $14,130 in self-employment taxes. Lisa contributed $19,500 to her traditional Solo 401(k), and makes an employer contribution to her traditional Solo 401(k) of $18,587. Lisa is married to Joe who makes $75,000 in W-2 wages. Lisa and Joe claim the standard deduction.

The deduction for retirement plan contributions is factored into the determination of QBI. Thus, in Lisa’s case, her Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($100,000 plus $75,000 less $7,065 less $19,500 less $18,587 less $24,800 = $105,048) = $21,010; or,
  • 20% of QBI: 20% times ($100,000 less $7,065 less $19,500 less $18,587 = $54,848) = $10,970

In this case, Lisa’s Section 199A deduction is $10,970.

QBI has the effect of making certain income “80% income.” What I mean by that term is that only 80% of the income is subject to income tax. This has a flip side – some deductions become only “80% deductions,” meaning that only 80% of the deduction generates a tax break.

Notice that the Solo 401(k) contributions reduce the QBI deduction. Thus, Solo 401(k) contributions are now “80% deductions” due to the QBI regime. For example, if your marginal tax rate is 22 percent, the marginal tax rate savings on your traditional 401(k) employee contribution is only 17.6 percent. But years later, when you withdraw the money from the Solo 401(k) the money will be “100% income.” You will not get a QBI deduction for those withdrawals.

I blogged more about the 80% deduction phenomenon here.

This will cause many sole proprietors to consider Roth Solo 401(k) employee contributions instead of traditional Solo 401(k) employee contributions, since the the tax savings on traditional self-employed employee contributions is reduced as a result of the QBI deduction.

Note further that for the Solo 401(k) employer contribution there is no choice to be made because there is no option to make a Roth employer contribution. All employer contributions must be traditional contributions.

Another observation: If Lisa and Joe had a low enough adjusted gross income (under $105,000) and Lisa made a deductible $6,000 contribution to a traditional IRA, that contribution would not have counted against her QBI. A contribution to a health savings account would also not have lowered her QBI.

For taxpayers whose Section 199A deduction is limited by 20% of QBI, contributions to traditional IRAs and HSAs should be favored over self-employment retirement plan contributions, since the IRA and HSA deductions are 100% deductions while the self-employment retirement plan contributions are 80% deductions. Hat tip to Jeff Levine who made the retirement plan contribution prioritization point on Twitter.

For taxpayers whose Section 199A deduction is limited by 20% of taxable income, contributions to traditional IRAs, HSAs, and self-employment retirement plans are all 80% deductions, and thus Section 199A normally does not factor into determining how to prioritize these contributions. However, all of these are tools taxpayers may be able to use to lower taxable income to qualify for a Section 199A deduction, as discussed in the Managing Taxable Income section below.

S Corporation

Assume the facts are the same as the previous example, except for the following differences. Lisa operates her business as a wholly-owned S corporation instead of as sole proprietorship. Before any sort of compensation, the S corporation makes $100,000. Assume that in this case, the S corporation pays Lisa $50,000 of W-2 wages, which is further assumed to be reasonable. Lisa makes employee contributions of $19,500 to her traditional Solo 401(k) from those wages. The S corporation makes the maximum employer contribution of $12,500 (computed as $30,500 of Box 1 W-2 wages plus $19,500 of elective deferrals times 25 percent). Thus, Lisa will have flow-through income from the S corporation (reported to her on a Schedule K-1) of $33,675 ($50,000 less $12,500 less $3,825 — the employer portion of the payroll tax).

Thus, in Lisa’s case, her Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($50,000 plus $33,675 plus $75,000 less $19,500 less $24,800 = $114,375) = $22,875; or,
  • 20% of QBI: 20% times ($33,675 — the QBI) = $6,735

In this case, Lisa’s Section 199A deduction is $6,735 because in the S corporation structure, the business income is split between a salary the S corporation pays her (which is not QBI) and the flow through profit of the S corporation, which is QBI (assuming it is domestic trade or business income).

The S corporation has various pros and cons from a tax perspective. Lower employment (payroll) taxes are a significant benefit, while lower maximum employer retirement plan contributions and lower Section 199A deductions are drawbacks.

Managing Taxable Income

Jackie is a lawyer operating as a sole proprietor. Law is one of several specified service trade or businesses (“SSTBs”) where the benefits of Section 199A are completely phased out if your taxable income exceeds $213,300 ($426,600 for married filing joint taxpayers using 2020 numbers). In 2020 Jackie has $240,000 of Schedule C income from the business. His self-employment taxes are $17,075 in Social Security taxes and $6,428 in Medicare taxes, for a total of $23,503 reported on Schedule SE. Jackie takes the standard deduction.

Jackie’s taxable income is thus $215,848 ($240,000 less $11,752 less $12,400). Because Jackie’s QBI is from an SSTB and his taxable income is above $213,300, he cannot claim any Section 199A deduction.

Now let’s add some tax planning to the scenario. Imagine that early in 2020 Jackie realizes he won’t qualify for the Section 199A deduction based on his numbers. He decides to open a Solo 401(k), which he can make an $19,500 employee traditional contribution to, and he can make an employer contribution of $37,500 for total contributions of $57,000 (the maximum allowed). This radically changes his Section 199A math, since (as will be demonstrated) his taxable income is now below $163,300. Once your income is below $163,300, you qualify for the Section 199A deduction only subject to the computational limits. Thus, in Jackie’s case, his Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($240,000 less $11,752 less $12,400 less $57,000 = $158,848) = $31,770; or,
  • 20% of QBI: 20% times ($240,000 less $11,752 less $57,000 = $171,248) = $34,250

Thus, Jackie’s Section 199A deduction is now $31,770! By managing his taxable income (by maximizing retirement savings), Jackie turned a $57,000 deduction into a more than $88,000 of deductions. Sure, the $57,000 deduction for retirement plan contributions is an “80% deduction,” but it creates the additional $31,770 of a Section 199A deduction (which is itself a “100 percent” deduction).

Jackie also lowered his marginal federal income tax rate from 35 percent to 24 percent and reduced his taxable income from $215,848 to $127,078!

Note that contributions to a health savings account would be another tool to deploy to lower your taxable income if you are concerned about Section 199A’s taxable income limitations.

Taxpayers bumping up against Section 199A taxable income limitations will likely need to prioritize traditional employee contributions to Solo 401(k) plans over Roth employee contributions. In addition, self-employed taxpayers bumping up against the taxable income limits in 2021 may want to establish 2021 Solo 401(k)s (if they are eligible to do so) to lower taxable income in order to qualify for the Section 199A deduction.

It will be wise for taxpayers to consult with tax advisors to run the numbers on Section 199A and other tax planning considering the complexity of the rules and the potential benefits of successful planning.

Charitable Contributions

The IRS gave us a bit of a head-scratcher in the instructions to the new Form 8995. The Form 8995 is used (starting with 2019 tax returns) to compute the QBI deduction. In the instructions, it states that charitable contributions reduce QBI.

Here is an example of how that rule would play out:

Cosmo is the sole shareholder of Acme Industries, an S corporation. In 2019, Acme reports QBI operating income of $100,000 to Cosmo on his Form K-1. It also reports $1,000 of charitable contributions made by Acme during 2019. The total QBI Cosmo can claim from Acme Industries is only $99,000, as the charitable contribution reduces QBI, according to the IRS. This is true even if Cosmo claims the standard deduction and thus has no use for the charitable contribution on his 2019 tax return.

Personally, I believe the IRS is on questionable ground in claiming charitable contributions reduce qualified business income. However, with some rather simple tax planning (which I generally believe to be prudent), you can avoid this issue altogether. If you want to make a charitable contribution, simply do so in your own name. Do not have your business — whether an S corporation, a small partnership, or a sole proprietorship, make the charitable contribution.

Rental Real Estate

The IRS and Treasury issued Notice 2019-7 and Revenue Procedure 2019-38 providing a safe harbor under which rental real estate activity can qualify for the Section 199A deduction. A safe harbor is a set of requirements, which, if satisfied, automatically qualify a taxpayer for a particular benefit. Stated differently, a safe harbor is a sufficient, but not necessary condition, to receive a benefit.

While rental activities that constitute a trade or business can still qualify for the deduction if they do not meet the requirements of the safe harbor, as a practical matter it will be much easier to sustain the deduction if you can qualify for the safe harbor.

Requirements

The requirements to satisfy the safe harbor with respect to any “rental real estate enterprise”  (a “RREE”) are as follows:

  • Separate books and records documenting the income and expenses of the RREE must be maintained.
  • At least 250 hours per year of qualifying activity must be done with respect to the RREE.
  • Starting in 2020, detailed records documenting the time spent on the RREE must be maintained (see Revenue Procedure 2019-38).
  • A statement electing the application of the safe harbor must be attached to the tax return.

Multiple Rental Properties

Rental property can be combined for purposes of determining if you have an RREE. However, residential and commercial real estate cannot be aggregated and must be kept separate. Thus, at a minimum if you own both commercial and residential property, you have two RREEs, and you must apply the tests to each separately to determine if each RREE qualifies for the safe harbor.

Qualifying Activities

In a bit of good news, the 250 hours can be done by the owner, agents, employees, and/or independent contractors. However, many activities do not count toward the 250 hours, including building and long-term redevelopment, finding properties to rent, and arranging financing. Qualifying activities include collecting rent, daily operation of property, negotiating leases, screening tenants, and maintenance and repairs.

Triple Net Leases

Triple net leases do not qualify for the safe harbor. For purposes of the rule, these include “a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities.”

House Hacking

For those using house hacking to pursue financial independence, there are several considerations. If you house hack by renting spare bedrooms in your primary residence (tenants, Airbnb, etc.), then you do not qualify for the safe harbor with respect to the rent generated by your primary residence. However, if your house hack consists of renting out separate units in a single building, the rental income could qualify for the safe harbor if (i) those other units are separate residences and not your own residence for any part of the year and (ii) you otherwise satisfy the requirements of the safe harbor.

REIT Mutual Fund Dividends

Dividends from REITs and REIT mutual funds can qualify for the QBI deduction. Generally, box 5 of Form 1099-DIV will indicate those REIT dividends which qualify as Section 199A dividends.

Example

In 2018 Luke makes $50,000 from his W-2 job. He operates a sole proprietorship that generates a $4,000 taxable loss (which would have been QBI had it been net income). Luke also receives $3,000 of dividends from the Acme Real Estate Mutual Fund, which he holds in a taxable account. Acme’s Form 1099-DIV provided to Luke indicates in box 5 that $2,400 of the dividends are Section 199A dividends. Luke claims the standard deduction. In Luke’s case, his Section 199A deduction is the lesser of:

  • 20% of Taxable Income: 20% times ($50,000 less $4,000 plus $3,000 less $12,000 = $37,000) = $7,400; or,
  • 20% of REIT Dividends: 20% times $2,400 = $480

Thus, Luke’s Section 199A deduction is $480. He gets this deduction even though the dividend was paid by a mutual fund and even though he had a QBI loss. His QBI loss will carryover to 2019, and will reduce his 2019 QBI that potentially qualifies for the Section 199A deduction.

Lastly, note that if Luke held the Acme mutual fund shares in a retirement account (traditional and/or Roth IRA/401(k), etc.) or a health savings account, the REIT dividend would not have qualified for the Section 199A deduction.

Conclusion

Even as of January 2021, taxpayers and practitioners are learning new wrinkles in the Section 199A QBI deduction. For taxpayers with side hustles and small businesses, it can represent a significant income tax break. Some taxpayers will need professional help to determine how best to maximize the deduction.

Further Reading

I have written several blog posts addressing the Section 199A QBI deduction. Here are the links below:

Introductory Post

Section 199A and Retirement Plans

Read why the Section 199A QBI deduction may mean a Solo 401(k) is better than a SEP IRA

For the self-employed, the Section 199A QBI deduction may present an opportunity to do more efficient Roth IRA conversions.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

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. Please also refer to the Disclaimer & Warning section found here.

Section 199A for Beginners

Introduction

Tax is a crucial consideration for those with small businesses and side hustles. A new tax provision, Section 199A, passed as part of Tax Reform in December 2017, gives many small business owners and side hustlers a deduction determined with respect to their “qualified business income” (or “QBI”).

So what’s going on? Why would you get a tax deduction for a certain type of income? The short answer is that the Section 199A deduction was needed to help level the playing field for small businesses (especially manufacturers) vis-à-vis large corporations. Tax Reform cut taxes for corporations (generally from 35 percent to 21 percent). To keep small businesses, many of which are taxed on individual tax returns at federal rates up to 37 percent, competitive with larger corporations, Congress enacted a partial deduction for qualified business income. The deduction has the effect of lowering the federal income tax rate on that income.

The QBI deduction also applies to so-called Section 199A dividends. Please see the discussion further below regarding Section 199A dividends.

Do I Qualify for the Section 199A Deduction?

The bad news is that, even for a tax rule, Section 199A is incredibly complex. The much better news is that most of that complexity applies to about 10 percent or less of taxpayers. For 90 plus percent of taxpayers, it isn’t too complicated!

To figure out if it is going to be complicated for you, ask yourself one question (all amounts as applicable for 2021):

Is my taxable income $164,900 or less?

If you’re married filing a joint tax return (“MFJ”), change the question to

Is my taxable income $329,800 or less?

For 2020, apply the above questions with $163,300 for single taxpayers and heads of household, and $326,600 for MFJ taxpayers. For 2021, married filing separate taxpayers use $164,925 as their number.

Remember, the key number is taxable income. Taxable income is your adjusted gross income less your standard deduction ($12,550 in 2021 for singles, $18,800 for heads of householder, and $25,100 for MFJ) or your itemized deductions. So if you take the standard deduction, you’re looking at adjusted gross income of $177,450 for singles, $183,725 for heads of household, and $354,900 for MFJ filers. Those are high thresholds for most Americans and for most of those seeking financial independence).

Section 199A Basic Calculation

If you answered Yes to your bolded question, your Section 199A deduction is computed based on a relatively simple (for tax) calculation. Your Section 199A deduction is the lesser of

  1. 20 percent of your taxable income less your “net capital gain” which is generally your capital gains plus your qualified dividend income (“QDI”) or
  2. 20 percent of your QBI.

Here are two examples to illustrate the calculation (all examples avoid discussing self-employment tax for ease of illustration):

Example 1: Phil has $100,000 of W-2 wage income, $1,000 of QDI from mutual funds owned in taxable accounts, makes $10,000 from a trade or business side hustle reported on Schedule C, and claims the standard deduction on his tax return. Phil’s Section 199A deduction is the lesser of

  1. 20% of Phil’s taxable income less net capital gain ($100,000 of wages, plus $1,000 QDI plus $10,000 of QBI less $12,000 standard deduction less $1,000 “net capital gain” – in this case, his QDI – equals $98,000. $98,000 X 20% = $19,600) or
  2. 20% of Phil’s QBI ($10,000 X 20% = $2,000).

Thus, Phil’s Section 199A deduction is $2,000, fully 20 percent of his side hustle income.

Example 2: Mary owns a sole proprietorship engaged in a domestic trade or business which earned $100,000 this year reported on Schedule C. Mary also earned $1,000 of QDI from mutual funds owned in taxable accounts and claims the standard deduction on her tax return. Mary’s Section 199A deduction is the lesser of

  1. 20% of her taxable income less net capital gain ($100,000 of Schedule C income plus $1,000 QDI less $12,000 standard deduction less $1,000 “net capital gain” – in this case, her QDI – equals $88,000. $88,000 X 20% = $17,600) or
  2. 20% of her QBI ($100,000 X 20% = $20,000).

Thus, Mary’s Section 199A deduction is $17,600, 17.6 percent of her sole proprietorship income.

Section 199A is great news for side hustlers and pretty good news for sole proprietors and other owners of flow-through businesses. Why the slight benefit reduction for our sole proprietor? The answer lies in the benefit of the standard deduction (or itemized deductions, if applicable). Since Mary already had the standard deduction protecting some of her QBI from full taxation, the Section 199A deduction was reduced to account for that benefit.

Note that if Mary had another source of income (other than long-term capital gains or qualified dividend income), such as a Roth conversion amount, or a spouse with income, that income would increase her taxable income limitation and she could qualify for up-to the full 20 percent QDI deduction.

What is QBI?

Now that we have the calculation illustrated, we must ask what is “qualified business income” (“QBI”)? Generally, QBI is domestic income from a trade or business (as defined under normal U.S. tax principles) received by a sole proprietor or by an individual from a “flow-through” business (a partnership, LLC, S-corporation, trust, or estate). Some important considerations:

  • QBI does not include wage income (W-2 income).
  • It is important to maintain documentation supporting that the activity is a trade or business.
  • It is important that the activity not be considered a hobby.
  • Rental income from the active conduct of a rental real estate trade or business is QBI. Income from the renting out of buildings where the owner is not engaged in a real estate trade or business is not QBI. Real estate may become a hot-spot for disputes between the IRS and taxpayers.

High Income Taxpayers

What if you answered No to your question? If you have QBI, you’re likely to need the assistance of a qualified tax professional. The rules get complicated quickly. For those with taxable income above $164,900 ($329,800 for MFJ, $164,925 for MFS), their Section 199A deduction is subject to a limitation and possibly a second additional limitation, as follows:

  1. For taxpayers over the taxable income thresholds, all QBI is subject to a limitation on the Section 199A deduction based on W-2 wages paid by the business and the unadjusted asset basis in the business. The more of these attributes, the greater the Section 199A deduction. Note that unadjusted asset basis is generally the acquisition cost of property. It includes tangible property (including buildings) but does not include land.
  2. Income from a specified service trade or business suffers an additional limitation. The Section 199A deduction for such income is phased out for taxable incomes between $164,900 and $214,900 ($329,800 and $429,800 for MFJ filers) (using 2021 numbers).

The preamble to the proposed regulations states that a “specified service trade or business” is (1) any trade or business involving the performance of services in the fields of health, law, 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 or owners, and (2) any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities . . . partnership interests, or commodities.”

The general idea behind the specified service trade or business is that Congress wanted to prevent high earning doctors, lawyers, accountants, etc., from benefiting from Section 199A. Congress intended for the benefits to generally go to manufacturers.  Manufacturers will generally find themselves only subject to the first limitation, and many will have buildings and equipment with tax basis and/or will pay significant W-2 wages to employees and thus will not find the limitation to have much effect.

For those subject to these complex limitations, there can be significant benefits from doing planning and restructuring with the assistance of qualified tax advisors to maximize their Section 199A deduction. Such planning can include planning to increase current year tax deductions (through, for example, increased retirement plan contributions) to reduce taxable income below the relevant testing thresholds.

Section 199A Dividends and Income from Publicly Traded Partnerships

Qualified dividends from real estate investment trusts (“REITs”) (Section 199A dividends) and ordinary income from publicly traded partnerships qualify for the Section 199A deduction. There is no need for the taxpayer to be in a trade or business and there are no limitations based on taxable income. In terms of sheer volume, I expect more returns will claim this Section 199A QBI deduction than the QBI deduction for “normal” qualified business income discussed above.

It is important to note that dividends and other income received in tax advantaged accounts (IRAs, 401(k)s, HSAs, other retirement accounts) does not qualify for the Section 199A deduction.

Tax Reporting

Taxpayers report their QBI deduction on either a Form 8995 or a Form 8995-A (for the 2019 tax year and later). Box 5 of Form 1099-DIV (Section 199A dividends) reports the dividends that qualify for the QBI deduction.

Further Reading

I published a more detailed Section 199A post here. It provides more examples of the application of Section 199A.

I published a post discussing the Section 199A QBI deduction and how the concept interacts with small business retirement plans (click here).

I published a post on a potential planning opportunity available to some self-employed individuals to capitalize on the interplay of self-employed income, Roth conversions, and the Section 199A deduction here.


FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This posting 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. Please also refer to the Disclaimer & Warning section found here.