Some entrepreneurs should consider abandoning, temporarily, traditional retirement accounts like 401(k)s and IRAs.
Confusingly, other business owners may want to do just the opposite and boost their use of traditional retirement accounts.
Still another group of business owners probably want to sharpen their pencils and look seriously at a multi-year Roth conversion strategy.
If you own a business, therefore, you want to learn the gritty details of new law. And consider carefully how it changes taxation of an individual business owner’s income.
Sec. 199A Deduction Substitute for IRA or 401(k)
A first technique some small business owners in states without income taxes may want to consider? Using their Sec. 199A deduction as a substitute for a traditional IRA or 401(k) retirement account.
But let me explain this technique using a simple example.
Suppose you run a successful sole proprietorship earning $100,000 a year. Further say you’re married and will use in 2018 the new $24,000 standard deduction.
Your taxable income in this case equals $76,000 before the Sec. 199A deduction.
The Sec. 199A deduction in this case, however, adds another deduction to your return. That deduction equals 20% of the $76,000 of taxable income, or $15,200, which drops your taxable income another $15,200 down to $60,800.
And so here’s where Sec. 199A changes retirement planning…
In this situation, if you operate your business and live in a state without income tax, you have little reason to use a tax-deferred retirement account. You may as well use the tax-sheltered income and the savings created by the $15,200 Sec. 199A deduction for retirement savings.
Note: Seven states don’t tax income: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.
Rather than contribute, say, $5,500 to your IRA and possibly your spouse’s IRA, you may just want to contribute that money to a potentially taxable account.
How Tax Accounting Works
No, wait, I know that sounds counter-intuitive. But consider how the tax accounting works in a situation like this.
First, you don’t need to contribute to an IRA or 401(k) to get a tax deduction that helps fund your retirement savings.
For example, you don’t need a $5,500 IRA contribution to put a $5,500 tax deduction on your tax return. You actually get an automatic $15,200 tax deduction simply because you own a profitable business.
Second, the new Sec. 199A tax deduction itself shelters investment income that you might have paid federal income tax on prior to Sec. 199A.
At the income level described here, the Sec. 199A deduction pushes the household taxable income down well into the new 12% tax bracket which means that roughly $17,000 of your qualified dividend income and long-term capital gain income will be subject to a 0% tax rate.
Note: To learn where the 12% tax rate bracket ends for other filing statuses, you can look at Oblivious Investor’s web post here.
That $17,000 of “breathing room” maybe doesn’t sound like that much space. But you might actually be able to have nearly $1,000,000 in a stock market index fund before you pay taxes on qualified dividends and long-term capital gains.
Note: Qualified dividends from the Vanguard total stock market index fund run about 2%.
IRA Deduction May Reduce Sec. 199A Deduction
Now, yes, you are absolutely correct that contributing $5,500 to a traditional IRA or 401(k) gets that taxpayer another $5,500 of annual tax deduction. That deduction annually saves her or him perhaps another $660 of taxes in a situation like that described here. But maybe those savings aren’t that compelling.
Do note someone further reduces their taxable income with an IRA or 401(k) contribution and that that reduction also reduces their Sec. 199A deduction. (In the example given here, that reduction in the Sec. 199A deduction “costs” about $130 of lost Sec. 199A tax savings.)
Now we’re talking not $660 of lost annual tax savings but maybe $530 of lost savings.
And then look at the big picture where someone foregoes those annual tax savings by using a taxable account. Over 35 years, she or he accumulates roughly $500,000 in real dollar terms (if they earn five percent annually and contribute $5,500 each year). The taxpayer will have paid $18,000 to $19,000 in income taxes over those 35 years. Which is a lot. But she or he then draws down that money without paying income taxes.
That seems a reasonable choice for some taxpayers living and working in or planning to retire to states with no or very low state income taxes…
Other Disadvantages of IRA and 401(k) Accounts
You know what else to remember? Remember you lose some other subtle benefits by putting money into an IRA or 401(k) account.
Often we don’t think much about these other lost benefits, but they become more significant in a example like that described here.
Consider, for example, these drawbacks of an IRA or 401(k) plan as compared to a taxable account that isn’t actually taxable:
- IRA or 401(k) accounts convert tax-free and preferentially taxed qualified dividends income and long-term capital gains (due to the 0% tax bracket and the 15% tax bracket) into ordinary taxable income.
- IRA or 401(k) accounts eventually subject you to required minimum distributions in retirement, which may force you to realize income and liquidate your portfolio even if you don’t need the money.
- With an IRA or 401(k) account, you may find yourself paying early withdrawal penalties or subject to more complicated withdrawal math if you retire or draw money before reaching age 59 and 1/2.
- IRA or 401(k) accounts conceivably limit your investment choices. Direct real estate investment and small business ownership become pretty impractical inside a tax-deferred investment account, for example.
- Taxable accounts may provide additional tax saving opportunities during the years you accumulate in the form of foreign tax credits, tax loss harvesting and non-cash charitable contributions.
- Taxable accounts provide some taxpayers with meaningful estate planning benefits. The ability to gift stocks to heirs without income tax consequences, for example. And the Sec. 1014 step-up in basis when a shareholder passes away (which means heirs such as a spouse avoid capital gains taxes).
The long and short of it? For some self-employed middle-class taxpayers in states with no or low state income tax, the IRA or 401(k) option has lost some or even much of its luster.
Sec. 199A Deduction Substitute for Roth Account
Once you understand the tax accounting reviewed in the preceding paragraphs, another actionable insight may come into focus… For some self-employed taxpayers, especially those living in states with either no state income taxes or very low state income taxes, Roth-IRAs and Roth-401(k) options lose much or even all of their attraction.
A Roth-style account, as you probably know if you’re reading this, doesn’t give you a immediate tax savings. (In the preceding paragraphs’ example, this tax savings runs $500 to $600 per $5,500 contribution.)
But even so, a Roth-style account offers benefits: You escape income taxes on the investment income earned inside the account. You don’t have to take required minimum distributions (though your heirs will.) And neither you nor your heirs pay income taxes on the money drawn from the account.
These benefits, however, lose their attraction for a small business owner enjoying a generous Sec. 199A deduction and paying a 0% qualified dividends and 0% long-term capital gains federal tax rate because of that Sec. 199A deduction.
In essence, Sec. 199A gives these self-employed taxpayers in states without a state income tax the same tax accounting–except without the extra complexity and restrictions of a Roth.
Taxpayers in states with very low state income tax rates get nearly the same accounting–but again without the extra complexity and restrictions of a Roth.
Sec. 199A Roth Conversions
Another connection between Sec. 199A and Roth accounts: Business owners with significant tax-deferred retirement account balances should look at the option of using the Sec. 199A deduction to avoid paying income taxes on Roth conversions.
In other words, a business owner with a $20,000 or $40,000 or $60,000 Sec. 199A deduction might in effect use that deduction to shelter $20,000 or $40,000 or $60,000 of “Roth Conversion” income from federal taxes.
Just so you know? I am not a hardcore fan of Roth-style accounts (something I’ve chattered lots about in blog posts before, such as Are Roth-IRAs and Roth-401(k)s Really a Good Idea.)
But federal income tax rates are noticeably lower for middle class and upper class taxpayers for at least the next few years even before the Sec. 199A deduction.
Maybe, given those already low rates, business owners should not piddle away the tax savings from Sec. 199A. Maybe, instead, they should use the Sec. 199A loophole to restructure their retirement savings for the long run.
Over the next few years, some business owners might easily move a few hundred thousand dollars from tax-deferred retirement accounts to Roth-style accounts without (in one sense) paying additional income taxes.
Escape Sec. 199A Disqualification with Pension
One other wrinkle related to the interplay of Sec. 199A and retirement planning for high income taxpayers. You may be able to escape Sec. 199A disqualification by ratcheting up your pension contributions.
I know. Confusing, right? But let’s dig into the details.
Okay, so as noted in earlier paragraphs, some middle-class and even upper-middle-class small business owners may need to reassess their use of IRAs and 401(k) accounts and possibly dial down their contributions.
A few folks may also want to get aggressive about Roth conversions over the next few years due to Sec. 199A.
However, some high income taxpayers may need to look at dialing up their contributions to tax deferred retirement accounts (and dialing down any Roth conversions) in order to get the Sec. 199A deduction.
Here’s why: A single taxpayer with a taxable income in excess of $207,500 or a married taxpayer with taxable income in excess of $415,000 loses the Sec. 199A deduction if she or he earns that income in a “specified service trade or business,” such as white-collar profession… or if he or she runs a business that doesn’t have employees with W-2 wages or depreciable assets.
This disqualification and limitation stuff gets complicated quick. (I discuss the rules on specified service business disqualification in more detail here: Sec. 199A Pass-thru Entity Deduction and the Principal Asset Disqualification. And I cover the W-2 wages and depreciable assets limitations in detail here: Sec. 199A Deduction Phase-out Calculations.)
But the basic rule goes like this: In order to not lose the Sec. 199A deduction due to W-2 wages or depreciable assets limitations or due to being a specified service business, you need to have taxable income of $157,500 or less if single and taxable income of $315,000 or less if married.
A taxpayer subject to these “income-based” eligibility requirements, therefore, may want to arrange for larger pension contributions that push down their income to a level that allows them to take the Sec. 199A deduction.
For example, suppose you are a single taxpayer who enjoys $207,500 of taxable income from a successful small business sole proprietorship. Also suppose your operation requires no W-2 employees and employs no depreciable assets.
With this profile, you get no Sec. 199A deduction. Zero.
Requalifying for Sec. 199A with a Pension
However, if you set up a pension plan with a large contribution that pushes your income below the threshold amount, you regain the ability to use the Sec. 199A deduction. For example, if you set up a one-person 401(k) plan and use that to make a $50,000 pension fund contribution, that contribution lowers your taxable income to $157,500.
With a taxable income equal to $157,500 you don’t need to worry about W-2 wages or depreciable assets (or about being in a specified service business for that matter) to get the 20% Sec. 199A deduction.
The 20% Sec. 199A deduction, by the way, equals $31,500 if your taxable income equals $157,500.
In the example described here, then, a $50,000 pension fund contribution may mean you add a $50,000 pension contribution to your federal and state tax returns as well as a $31,500 Sec. 199A deduction to your federal tax return.
Note: The pension fund contribution will probably appear on both your federal and state income tax returns. The Sec. 199A deduction will probably only appear on your federal income tax return.
This snowballing of the deductions adds incentives for the business owner to “go big” with their pensions.
Here’s another example: Suppose instead you are married and earn $415,000 in taxable income in a specified service business operated as a one-person operation: A locum tenens physician or a management consultant or a performing artist.
At $415,000 in taxable income, sorry, you don’t get the Sec. 199A deduction.
If, however, you setup a defined benefit pension plan that requires a $100,000 pension fund contribution, that drops your income to $315,000 and gives you a $63,000 additional deduction.
If you’ve considered a defined benefit pension plan before but passed on the idea due to the cost, that extra $63,000 of deductions may provide the extra financial incentive you need in order to make the move.
Final Comments about How Sec. 199A Changes Retirement Planning
Let me close with two quick closing comments about the interplay of Sec. 199A with your retirement plan.
First comment: Clearly, Sec. 199A changes retirement planning for some small business owners. Most business owners need to reexamine their retirement plans. You may choose to stay with your current approach. But the landscape has changed. Make sure your plans shouldn’t change in response.
Second comment: The Sec. 199A statute runs from 2018 through 2025. Then, per the current law, the deduction goes away. As a result, business owners may want to act quickly in order to get as many years of Sec. 199A benefits as they can. And then, unfortunately, that 2025 sunset means in 2026 things will change again and you may need to update your retirement plan once more.
Additional Sec. 199A Information
If you want to learn more about Sec. 199A, this blog also discusses other key elements of the Sec. 199A in these posts:
Finally, if you’re a tax practitioner or other professional who needs to really understand how Sec. 199A works in order to serve clients, consider purchasing and downloading our Maximizing Sec. 199A Deductions monograph.