Using Retirement Plans to Benefit from the 20% Deduction on Pass-Through Income
On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (“TCJA”) was signed into law by President Trump. One of the major provisions of the TCJA was the addition of Internal Revenue Code (“IRC”) section 199A, which provides up to a 20% deduction for “qualified business income” (“QBI”) received by taxpayers from a pass-through entity (sole proprietorship, S corporation, partnership, or limited liability company taxed as a partnership). This deduction may be limited for taxpayers who receive pass-through income from a “specified service business,” which includes performing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business in which the principal asset is the reputation or skill of one or more of its employees.
You can get more detailed information on the QBI deduction here.
For single taxpayers, the deduction is phased out beginning at $157,500 of taxable income and is completely phased out at $207,500 of taxable income. For those taxpayers married and filing jointly, the deduction is phased out beginning at $315,000 of taxable income and is completely phased out at $415,000 of taxable income. For most taxpayers whose pass-through income is not from a specified service business, the deduction is generally the lesser of 1) 20% of QBI or 2) the greater of 50% of W-2 wages paid or the sum of 25% of W-2 wages paid plus 2.5% of the unadjusted basis in “qualified property.” This deduction is further limited to 20% of a taxpayer’s taxable income in excess of any net capital gain.
The Role of Retirement Plans
Given the potential tax benefit for taxpayers whose income is from a specified service business, the goal will be to reduce taxable income below the threshold for phase-out of the 20% QBI deduction. With the new limitation on the deduction for state and local taxes under the TCJA, taxpayers, especially those in high tax states, will need to look to other deduction sources to reduce their taxable income. Tax qualified retirement plans, both defined contribution (including 401(k) plans) and defined benefit plans (including cash balance plans), represent a potential source of substantial tax deductions for taxpayers. While retirement plans, as discussed below, usually are most beneficial for owners of entities with less than 50 employees, all affected business owners should ask their advisors whether they can increase their contributions to retirement plans in a sufficiently cost effective manner to help them to take advantage of the QBI deduction.
Defined Contribution Plans
A large percentage of specified services businesses already sponsor either a simplified employee pension plan (“SEP”) or a 401(k) profit sharing plan. Accordingly, the first step to reducing taxable income is to ensure that the taxpayer is making the maximum deductible contributions to their existing defined contribution plan (assuming they have one). In the case of defined contribution plans, this translates to $55,000 for a SEP plan for 2018* and, for 401(k) profit sharing plans, a maximum deduction of $55,000 for taxpayers under age 50 and $61,000 for taxpayers 50 or older through any combination of employee contributions, employer matching contributions, and employer ‘profit sharing’ contributions (aka non-elective contributions). In the case of both a SEP and a 401(k) profit sharing plan, the taxpayer will need to weigh the cost of additional contributions to employees compared to the tax savings from the 20% QBI deduction.
Defined Benefit Pension Plans
Defined benefit pension plans, including cash balance plans, require annual contributions as computed by an actuary to fund an annual pension benefit for participants beginning at retirement age under the plan. The current maximum annual pension payable at retirement that may be funded for in 2018 is $220,000. In order to fund the maximum annual pension benefit, taxpayers in their late thirties and early forties may be able to contribute close to $100,000 annually, those in their fifties may have annual contributions up to $200,000, and those in their sixties may have annual contributions in excess of $300,000. Thus, the deductions can be large and that is good news for those looking for substantial deductions to meet the threshold for the 20% QBI deduction.
The trade-off for the potentially large tax deductions is that defined benefit plans are complex, resulting in higher annual administration costs. They require annual actuarial calculations to determine the contributions required to be made to the defined benefit plan to fund the annual pension benefits and (if also maintained) the maximum contribution to the employer’s defined contribution plan, which may be reduced as a result of having a defined benefit plan. Contributions to a defined benefit plan are required to be made each year under the minimum funding requirements of IRC section 412. Accordingly, if the employer has a down year, it will still need to have the cash available to fund the defined benefit plan. Further, the non-highly compensated employees (generally those earning less than $125,000 in 2018), will need to receive a total contribution of about 7.5% of their compensation in either the defined benefit plan, the defined contribution plan, or a combination of the two in order for the taxpayer to make the maximum contributions allowed. Additionally, if the taxpayer’s business currently sponsors a SEP plan, it may not be able to also contribute to a defined benefit plan, depending on whether it is a model SEP or an individually designed SEP. Finally, it is important to note that the plan sponsor, not the plan participants, invests the assets held by the defined benefit plan. Thus, because the annual pension benefits are guaranteed, the plan sponsor bears the risk for the investment results of the plan trust.
Despite the complexity and costs, when properly designed by a competent actuary, a defined benefit plan alone or combined with a defined contribution plan can help high-income taxpayers in a specified service business reduce their income sufficiently to meet the threshold for the 20% QBI deduction.
While outside the scope of this article and not as valuable in terms of the deduction amount, taxpayers with QBI should also consider looking at health savings accounts and the medical deduction for self-employed individuals.
Taxpayers with income from a specified services business who are searching for ways to meet the income threshold for the 20% QBI deduction should consult with their tax advisor or retirement plan consultant to do a cost benefit analysis to evaluate whether changes or additions to their existing retirement plan(s) or adding additional plans can help them take advantage of the QBI deduction.
*Note: a SEP may still be established for 2017 provided the entity has not filed its 2017 tax return, which could provide the owner a maximum deduction of $54,000 assuming the maximum income is earned. Employees will also need to receive a contribution at the same percentage of compensation as the owner.