How Business Owners Can Use Retirement Plans to Save on Taxes
I recently wrote an article explaining the Qualified Business Income (QBI) deduction for small business owners. This ‘new’ deduction for owners of pass-through entities was created as a result of the Tax Cuts and Jobs Act. It can be a great benefit to business owners if properly planned for but it can also be very confusing. Unfortunately, many other business owners I’ve talked to have sometimes been given incorrect information about the deduction, particularly as it relates to certain specified-service businesses. Hopefully, the previous article clarified some of the exemptions, exceptions, and thresholds that are important to determine if and how much of a deduction you can take even if you own a specified service business. In the article I also mentioned several high-level strategies that you should consider if you’re close to or exceed the thresholds at which you can take the full deduction. Which strategies work best depend on the type of business you own and the amount of taxable income you generate. If you’re a specified service business and you exceed the allowable income levels, one objective I mentioned is to reduce your overall taxable income. My preferred way to do this, when possible, is to establish and fund a retirement plan for the business. Here’s how that works.
Qualified Business Income
Before I dive in, there are a few terms that need to be simplified. First, the deduction can be taken against qualified business income, which excludes such items as capital gains and interest. For simplicity, let’s assume QBI is the income generated by the products and services provided by the business and not income generated from activities such as investing – unless of course investing is part of your firm’s business.
Specified Service Business
For specified service businesses, the QBI deduction is available in full if the income from the business owner is $315,000 or less if filing jointly, or $157,500 if filing single or married/separately. The deduction phases out, however, at income levels above these thresholds until they are completely phased out at income of $415,000, and $207,500, respectively, for joint and single filers.
What is a specified service business? There is still some debate about that but the IRS thus far has provided the following ‘guidelines’:
A “specified service trade or business” means any trade or business involving the performance of services in the fields of health, law, accounting, consulting, 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 which involves the performance of services that consist of investing and investment management, or trading or dealing in securities. However, a trade or business that involves the performance of engineering or architectural services is not a “specified service.”
Let’s take a look at an example:
Jim is a doctor set up as a single member LLC and in his most recent year, his taxable income was $285,000 while his wife Jane has a salary of $85,000 working for a small regional manufacturer. Their combined income is $370,000 and since Doctors are defined as specified-service businesses, Jim will only qualify for a portion of the QBI deduction. In this case, Jim only qualifies for a 9% deduction because he and his wife have income above $315,000 but not more than $415,000. The deduction is decreased by 1% for every $5,000 above $315,000 which is how we got to the 9%. The QBI deduction is $25,650 – resulting in a tax liability of $74K. Fortunately for Jim, he hasn’t set up a retirement plan for his business yet.
After calling me for a brief overview of his tax situation, we discussed the QBI deduction and determined that Jim and Jane were quite comfortable with their current take-home pay, and could afford to contribute to a retirement plan without affecting their day to day lifestyle.
A regular 401K has an annual contribution limit of $18,500, which would help reduce taxable income but wouldn’t reduce the couple’s income enough to qualify for the full QBI deduction. As a self-employed business owner, however, there are other types of plans that allow for greater contributions.
We decided that Jim should establish a Solo or Self-employed 401K which has a maximum contribution of $55,000 annually plus another $6,000 catch-up because Jim is over 50 years old. The way this type of plan works is that the employee can make their contribution of $18,500 and the company can contribute 25% of earned income up to the allowable limit. In this case, Jim is the employee and his LLC is the employer, even if it’s a single-member LLC and a pass-through entity. As an employee, Jim is allowed to contribute up to $18,500 to his Solo 401K plus the $6,000 catch up contribution, but his employer (his own LLC) can also contribute 25% of his earned income towards the retirement plan – for a combined total of $61,000.
A contribution of that amount would reduce Jim and Jane’s taxable income enough to qualify for a greater portion of the QBI deduction. In the worksheet below, I have provided a breakdown of the taxes payable under the initial scenario on the top portion of the table, and compared it to the taxes payable with a fully funded Solo 401K retirement plan in the bottom section of the table.
With a combined taxable income of $370,000, Jim and Jane, married filing jointly, will qualify for a 9% QBI deduction as previously mentioned, resulting in taxes payable of $73,571.
The bottom portion of the table shows the calculation for taxes payable if a Solo 401K is established and funded to the maximum contribution amounts. The Employee Deferral Contributions of $18,500 and catch-up contribution of $6,000 adds up to $24,500. The employer can contribute an additional 25% of earned income but only to the allowable $61,000 max. In this case, after Jim contributes $24,500, the company can contribute an additional $36,500 because although 25% of earned income exceeds this amount, the combined contribution cannot exceed the IRS limit of $61,000.
The result of those contributions reduces Jim’s taxable income to $224,000. When I add back Jane’s salary, their total taxable income is $309,000, and now the couple can take the full 20% QBI deduction, or $57,000 – for a total tax savings of $24,512!
In the real world, we would also have to calculate the impact of self-employment tax, which is based on earned income and is required for the employer contribution to be allowed. In most cases, the additional expense incurred for self-employment tax is less than the tax benefit realized from the higher QBI deduction – resulting in an overall benefit to the business owner.
I want to reiterate that the case study has been simplified and that other variables have to be considered, but in my experience, establishing and/or increasing contributions to a retirement plan can help business owners maximize the QBI deduction if their income is at or near the phase out thresholds.
For income levels above that, there could potentially be another type of retirement plan, namely, a defined benefit plan, which might also be used to reduce taxable income below the phase out thresholds. The concept of a defined benefit plan is the same – except that the contribution amounts could potentially be higher, resulting in a greater reduction in taxable income.
If you’re a small business owner of a pass-through entity and you think you might not be able to take full advantage of the QBI deduction, consider analyzing your situation to determine if there are any strategies you could use to increase the deduction.
In a future example, I will provide a case study for a business that is not considered a specified service business. That is, any business other than a specified service business. While these types of businesses are not limited to the income limits relevant to specified service businesses, the amount of the QBI deduction may be limited for them as well. Fortunately, there are planning techniques to address these limitations as well.