199A Features Have a Big Impact on Retirement Accounts

The 199A deduction is one of the most complex parts of the 2017 Tax Cuts and Jobs Act. A couple of its features can have a big impact on retirement planning, and can allow taxpayers to deduct up to 20% of their qualified business income (QBI).

QBI is business income that:

  • comes from a qualified domestic trade or business, and
  • is passed through to the taxpayer from a sole proprietorship, partnership, S corporation, or LLC.
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Income Limits on the 199A Deduction

Once taxable income exceeds a threshold amount, the taxpayer must begin excluding service business income from QBI. There are 13 types of service businesses, including health, law, accounting, consulting, and some investment and trading activities.

The thresholds for 2019 are:

  • $160,700 for single filers and heads of households,
  • $160,725 for married taxpayers filing separate returns, and
  • $321,400 for joint filers.

How Does 199A Work for Service Business Income?

When taxable income exceeds the applicable threshold amount, service business income begins to phase out as QBI. Once taxable income exceeds the threshold amount by $50,000 (or $100,000 for joint filers), the phase-out is complete, and service business income is completely excluded from QBI.

How Does 199A Affect Retirement Contribution Deductions?

§199A affects retirement planning because a self-employed worker’s deductible retirement plan contributions reduce both taxable income, and QBI because the contributions are a business expense that is attributable to QBI in proportion to the taxpayer’s gross income from the qualified business.

The fact that retirement plan contributions reduce QBI means that the taxpayer effectively loses 20% of the tax deduction for the contribution. This is why some practitioners refer to retirement plan contribution deductions as “80% deductions” or “reduction deductions.”

Lower-Income Taxpayers’ 199A and Retirement Plan Contributions

When taxable income does not exceed the threshold amount, the taxpayer’s retirement plan strategy is pretty simple: Avoid deductible (pre-tax) contributions!

These taxpayers, along with taxpayers whose QBI comes from non-service businesses, should generally avoid contributions to:

  • Traditional IRA
  • SEP IRA
  • Simple IRA
  • Solo 401(k)
  • Defined benefit plan

Since these deductions reduce QBI, they effectively lop off 20% of the deduction for retirement plan contributions.

Better Options for Retirement Plan Contributions

Instead of deductible contributions, lower-income taxpayers should consider taxable contributions to their retirement plans. Obviously, the taxpayer loses the benefit of deducting the contribution. However, the taxpayer should still be able to claim the full 199A deduction for 20% of QBI.

These plans also generally provide for tax-free withdrawals, which can be especially valuable for taxpayers who expect their tax rate to stay the same or increase after they retire.

Tax-advantaged savings plans with non-deductible contributions include:

  • Health savings accounts (HSAs). However, these accounts are limited to taxpayers who have only high-deductible health insurance plans, and annual contribution limits are fairly low.
  • Roth IRAs, though these annual contribution limits are also fairly low.
  • Nondeductible traditional IRA contributions for workers whose income is too high for Roth IRA contributions.
  • Other Roth plans, such as a solo Roth 401(k) or a solo Roth IRA.
  • After-tax 401(k) contributions, if the plan permits.
  • Other taxable accounts, like savings accounts, certificates of deposit, etc.

Riskier Retirement Plan Options

More adventurous taxpayers might consider making “backdoor” Roth contributions by converting nondeductible IRA or after-tax 401(k) plan contributions to Roth status in the year of contribution. This avoids the IRA Roth income restrictions. The really stout of heart can even explore “mega backdoor” Roth contributions. However, not everyone agrees these are safe strategies.

In addition, Roth conversions of traditional IRAs or pre-tax 401(k) contributions generate income, but not QBI. Thus, lower income taxpayers should make sure the conversion will not push their taxable income over the threshold amount that limits the 199A deduction.

Higher-Income Taxpayers’ and Retirement Plan Contributions

The picture can be very different for higher-income taxpayers. Once taxable income exceeds the threshold amount, deductible retirement plan contributions that reduce both taxable income and QBI can make a lot of sense. The 20% reduction in the contribution deduction may be worth it if the contribution brings taxable income back below the threshold amount or the phase-out ceiling.

Our Tax Advisors Can Help

This blog post simplifies the rules for both the 199A deduction and retirement plan contributions for illustration purposes. Self-employed taxpayers who might qualify for the 199A deduction should consult with our tax advisors to more fully understand these rules. Please call the office to set up a consultation regarding your retirement planning.