- For lower-income taxpayers, the 199A deduction can effectively reduce the tax benefit of deductible contributions to retirement plans.
- For higher-income taxpayers, however, plan contributions may create or increase eligibility for the 199A deduction.
How Does the 199A Deduction Work?
The 199A deduction is one of the most generous parts of the 2017 Tax Cuts and Jobs Act. It is also one of the most complex. A couple of its features can have a big impact on retirement planning.
- comes from a qualified domestic trade or business, and
- is passed through to the taxpayer from a sole proprietorship, partnership, S corporation, or LLC.
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 threshold amounts 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.
Imagine, for example, three unmarried sole proprietors who each have $100,000 in qualified business income from a service business. Thus, the initial 199A deduction for each of them is $20,000 (20% of $100,000).
- Barry is a dentist whose taxable income is $150,000. Since his taxable income does not exceed the threshold amount, all of his service business income can be QBI. So his QBI deduction is $20,000.
- Bob is a lawyer whose taxable income is $175,000. Since his taxable income exceeds the threshold amount by less than $50,000, a portion of his service business income can be QBI. His 199A deduction will be less than $20,000.
- Bella is a consultant whose taxable income is $215,000. Since her taxable income exceeds the threshold amount by more than $50,000, none of her service business income is QBI. She cannot claim any 199A deduction at all.
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
This is 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.”
How the Reduction Deduction Works
Here’s an illustration. Let’s go back to our dentist, Barry. Let’s say his business pays him a $50,000 salary, in addition to his $100,000 in QBI. He makes a tax deductible contribution of 20% of his salary, or $10,000, to his SEP IRA.
This $10,000 deduction reduces Barry’s taxable income to $140,000. More importantly, it reduces his QBI to $90,000 – which reduces his 199A deduction from $20,000 to $18,000. As a result:
- Without the SEP contribution, Barry has a $20,000 deduction under 199A.
- With the SEP contribution, he has a total of $28,000 in deductions (the $10,000 SEP contribution plus the $18,000 199A deduction).
- So his $10,000 SEP contribution increases his total deductions by only $8,000.
In other words, a retirement plan contribution that would be fully deductible without 199A effectively becomes only 80% deductible. But Barry’s eventual distributions from his retirement plan will still be 100% taxable.
How Should Lower-Income Taxpayers Coordinate 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 a:
- 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.
How Should Higher-Income Taxpayers Coordinate 199A 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.
For instance, let’s return to Bella, our wealthy consultant. Remember that since her taxable income of $215,000 exceeds the phase-in ceiling of $210,700, her 199A deduction is completely eliminated because none of her service business income can be QBI.
However, if she can use deductible retirement plan contributions to lower her taxable income, she might be able to claim a 199A deduction that compensates for the loss of 20% of the contribution deduction.
Using Retirement Plan Contributions to Reduce Taxable Income
Let’s say that our consultant, Bella, makes the maximum $56,000 allowable contribution to a Solo 401(k), comprising:
- a $19,000 employee contribution, plus
- a $37,000 employer contribution (since, as a self-employed worker, she is her own employer).
These contributions reduce both taxable income and QBI. Thus, they bring Bella’s taxable income down to $159,000. Now that her taxable income is below the $160,700 threshold amount, all of her service business income can qualify for the 199A deduction.
Of course, her $56,000 in retirement plan deductions also reduce her QBI from $100,000 to $44,000, which gives her a 199A deduction of $8,800. The end result:
- With no retirement plan contributions, Bella has zero deductions.
- With her retirement plan contributions, she has a total of $64,800 in deductions — $56,000 for her retirement plan contributions, plus her $8,800 199A deduction.
As an added benefit, these combined deductions lower her taxable income to $145,200 – which lowers her marginal tax rate from 35% to 24%. Thus, her retirement plan contributions can really pay off, even if 199A effectively lowers the value of Bella’s deduction for them.
How Can Tax Advisors Help?
The discussion here simplifies the rules for both the 199A deduction and retirement plan contributions in order to illustrate how each affects the other. Self-employed taxpayers who might qualify for the 199A deduction should consult with their tax advisors to more fully understand these rules.
Of course, most taxpayers will have concerns that go beyond the interplay of 199A and retirement plan contributions. By consulting their tax advisors, taxpayers can also make sure that their chosen strategy best serves their overall business and retirement goals.
By Kelley Wolf, JD, LLM