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George F. Bearup, J.D. Senior Legal Trust Advisor

26-Jun-19

IRC 199A Tax Deduction: To Make, or Not to Make, a Retirement Plan Contribution, that is the Question

Take-Away: There are no fixed rules when it comes to the decision to make, or to not make, a tax deductible contributions to an IRA or qualified plan to better position the contributor to claim the qualified business income (QBI) deduction under IRC 199A. As a very broad generalization, if the contributor is young(er) and still a long way away from retirement, it is probably best to make a tax-deductible contribution to a retirement plan or IRA, even if that contribution lowers the amount of the IRC 199A income tax deduction that can be claimed.

Background: Owners of pass-through business entities like partnerships, S corporations, LLCs, and sole proprietorships are eligible to claim a 20% qualified business income (QBI) tax deduction. The deduction is claimed on the owner’s individual tax return, based on information provided by the business to the owner (on the K-1 that is provided to the owner.) This deduction does not, however, reduce the owner’s business income for self-employment tax or Medicare tax purposes, just income taxes.

Income Limits and ‘Tests’: Eligibility to claim the income tax deduction is tied to the individual’s reported income; above reported income levels the deduction is phased-out or completely eliminated. In addition, this income tax deduction is also restricted to a W-2 wages paid ‘test’ and/or the unadjusted basis of appreciated property (UBIA) acquisition held and used in the trade or business ‘test,’ both of which make calculating the available income tax deduction highly complicated.

  • Income Ceilings: For 2019 the full IRC 199A income tax deduction to be claimed by a married couple, their reported income cannot exceed $321,400. For a single person the full IRC 199A income tax deduction can be claimed if his/her income is $160,700 or less. Above these income levels, the IRC 199A deduction begins to be phased-out: for a married couple the maximum income where some of the IRC 199A income tax deduction can be claimed is $421,400, and for a single taxpayer the maximum amount is $210,700.
  • Wage/UBIA Limits: The W-2/UBIA limit with regard to the IRC 199A income tax deduction is controlled by a formula, which is the greater of: (i) 50% of the W-2 wages paid, or (ii) 25% of the W-2 wages paid, and 2.5% of the unadjusted basis of depreciable property acquired and held in the trade or business.
  • Taxable Income Limit: Finally, the IRC 199A income tax deduction cannot exceed 20% of the individual’s taxable income over capital gains. This limitation therefore implicates contributions to a tax-deductible retirement plan or IRA, since those deductible contributions to the plan will reduce the individual’s reported taxable income, thus creating yet another limitation on the amount that can be deducted under IRC 199A.

Examples: Some examples of when a retirement plan contribution can benefit, or hurt, a business owner who claims an IRC 199A qualified business income tax deduction (for ease referred to as a QBI deduction) follow. These examples tend to show what kind of an analysis is required to determine whether to contribute to a retirement account or IRA, opt instead for an after-tax Roth contribution, or how to go about maximizing the available IRC 199A QBI income tax deduction.

  1. Reducing Taxable Income: Greg is a single accountant with taxable income of $208,000 in 2018. Accounting is a specified service trade or business, which requires that the QBI deduction be phased-out. Greg’s income exceeds the end of that phase-out range for a single taxpayer [which is $207,500 in 2018]; accordingly, Greg cannot claim a QBI deduction under IRC 199A. If, instead, Greg contributes $51,000 to a simplified employee plan (SEP) that SEP contribution reduces Greg’s taxable income to $157,000. With Greg’s SEP contribution, neither the specified service trade or business limitation nor the W-2 wage/UBIA limitation applies. As a result of Greg’s SEP contribution in 2018, he can claim a QBI income tax deduction of $31,400 [20% X $157,000 = $31,400] in 2018.
  2. Increasing Taxable Income:  Becky, who is a married, files her income tax returns jointly with her spouse. Becky’s QBI in 2018 is $165,000. Becky is in the 22% marginal federal income tax bracket. Becky and her spouse claim the $24,000 standard deduction, which reduces her taxable income to $141,000. Becky’s IRC 199A QBI income tax deduction is $28,200 [20% X the lesser of her QBI or her taxable income.] Becky decides to convert $24,000 of her traditional IRA to a Roth IRA in 2018. That Roth conversion will increase Becky’s IRC 199A QBI income tax deduction by $4,800 up to $33,000. The Roth IRA conversion will increase Becky’s IRC 199A deduction, which has the effect of reducing the effective income tax rate on her 2018 reported taxable income from 22% to 17.6% [80% (deduction) X 22% (marginal income tax rate)= 17.6% (effective income tax rate.]
  3. Roth IRA over Traditional IRA: Brad is in the 30% marginal income tax bracket in 2016. He expects to be in the same 30% bracket when he receives distributions in his retirement. Brad has $5,000 of income that he wants to contribute either to a traditional IRA or to a Roth IRA.  The expectation is that the $5,000 will double in value by the time Brad retires. All else being equal, the after-tax amount that will be available to Brad when he retires will be the same whether he makes a contribution to a traditional IRA or to a Roth IRA.  Why? With a $5,000 pre-tax contribution of $5,000 to a traditional IRA, Brad will have $10,000 at his retirement (his contribution doubled), but after he pays 30% in income taxes on the $10,000, Brad’s after-tax in-hand amount in retirement will be $7,000 [$10,000 less 30% = $7,000.] With an after-tax Roth IRA contribution, after Brad pays 30% on his $5,000 in income taxes ‘up front’, he will have $3,500 left to contribute to his Roth IRA. When Brad finally retires, his Roth IRA balance will have doubled, so Brad will have $7,000 in his Roth IRA available in his retirement years [$3,500 X 2= $7,000.]  In short, Brad ends up, after-tax, with the same amount whether he contributes the $5,000 to a traditional IRA or a Roth IRA.
    • Now assume the same facts, but it is 2018 and Brad has QBI of $100,000. The $5,000 traditional IRA contribution will reduce Brad’s QBI to $95,000, and his IRC 199A QBI income tax deduction will drop to $19,000 [20% X $95,000 ($100,000 less $5,000 IRA contribution) = $19,000.] In effect, the traditional IRA deduction is only worth $4,000 instead of $5,000 to Brad, which leaves $300 of tax payable at the time of Brad’s IRA contribution. The traditional IRA versus Roth IRA comparison would then look like the following: With the traditional IRA contribution Brad’s after-tax contribution would be $4,700, with a value at Brad’s retirement of $9,400 [$4,700 X 2 (doubled in value) = $9,400] with a tax payable of $2,820, which leaves Bard with an after-tax value of his traditional IRA distribution in retirement of $6,580. With a Roth IRA contribution, Brad’s after-tax contribution is $3,500 [$5,000 X 30% (tax) = $3,500], which leads to a value at Brad’s Roth account in retirement of $7,000 [$3,500 X 2 (doubled) = $7,000.] Consequently, Brad is better off making the Roth IRA contribution than the traditional IRA contribution. An income tax deductible IRA contribution by Brad reduces his QBI which, in turn, reduces the size of Brad’s IRC 199A income tax deduction.
  4. Roth 401(k) over IRA: Dan’s taxable income is below the QBI limit, which permits him to qualify for the full IRC 199A income tax deduction. Dan’s Schedule C net income, i.e. his QBI, is $100,000 for the year. With no SEP contribution tax deduction, Dan’s QBI deduction is $20,000 [$100,000 (QBI) X 20% (IRC 199A deduction rate) = $20,000.] If Dan contributes $15,000 to his SEP for the year as a deductible contribution, his net business income for the QBI income tax deduction will be reduced $85,000, which means that Dan’s QBI income tax deduction will also be reduced down from $20,000 to $17,000 [$85,000 (QBI) X 20% (IRC 199A deduction rate) = $17,000.] With his $15,000 SEP contribution, that Dan’s QBI deduction will be reduced from $20,000 to $17,000. The net effect is that with the SEP contribution deduction ($15,000) and the reduced QBI deduction (a $3,000 reduction) the net SEP income tax deduction benefit to Dan will be $12,000. Restated, before Dan decided to make a SEP contribution, his QBI deduction was worth $20,000. After Dan’s decision to contribute $15,000 to his SEP IRA, the after-SEP contribution benefit to Dan is $32,000 [the $15,000 SEP deduction + the $17,000 QBI deduction = $32,000 total deduction.]
    • Note that before Dan contributed to his SEP his IRC 199A QBI deduction was $20,000. When Dan made his SEP contribution of $15,000, his total deductions should have been increased to $35,000 [the $20,000 QBI deduction + the $15,000 SEP contribution.] However, Dan’s net deduction will not be the full $35,000, only $32,000 [the $35,000 gross of the two deductions but less the QBI ‘deduction-reduction’ of $3,000 = $32,000.] While Dan increased his income tax deductions by the $15,000 that he contributed to his SEP IRA, he only receives a net benefit of 80% for his $15,000 SEP contribution tax deduction.
    • Another way to look at this scenario is that Dan only received 80% of the income tax deduction benefit attributed to his $15,000 SEP contribution. Yet when Dan retires, he will include 100% of that SEP contribution in his ordinary taxable income. This negative implication that arises from Dan’s QBI ‘deduction-reduction’ could be worse if the income tax rates increase when the SEP distribution is taken by Dan in his retirement years.
    • This ‘interplay’ between the SEP contribution deduction and the IRC 199A QBI income tax deduction can be mitigated if there is a contribution by Dan to a Roth 401(k) account, instead of making a SEP contribution or a contribution to another tax-deferred qualified plan. Assume that Dan contributes, instead, to a Roth 401(k) account and not a SEP. Dan could than take the full IRC 199A QBI income tax deduction of $20,000 (and, in effect, remove 80% of the problem, assuming that the loss of the income tax deduction does not push Dan’s taxable income over his QBI threshold amount.) Why? Because with a Roth 401(k) qualified plan contribution, there is no income tax deduction, so there is no reduction in Dan’s IRC 199A QBI income tax deduction. Additional benefits also arise with a contribution to a Roth 401(k) account, including: creditor protection, the Roth account grows income tax-free, and Dan will have no required minimum distributions (RMDs) in his retirement years, which will keep Dan’s retirement income at lower income tax brackets.

Retirement Contribution Factors: There is no easy answer to a decision to make a contribution pre-tax, or post-tax, to a retirement account when the goal is to maximize a business owner’s IRC 199A QBI deduction. Some generalities can help to assist the owner with that decision:

  1. Age: If the owner is younger and looks to many more years of work before retirement, it probably makes the most sense to make a tax-deductible retirement plan contribution. The build-up of tax-deferred growth in the retirement account will probably offset the income tax inefficiency caused by that the pre-tax contribution’s reduction to the size of the IRC 199A QBI income tax deduction. An owner who nears retirement may benefit by claiming the full IRC 199A QBI deduction (with an after-tax Roth contribution) because that will leave more after-tax dollars that the individual can invest in a manner that will not be subject to required minimum distributions when the owner is in retirement.
  2. Income Tax Rates: If the owner expects to be in a lower marginal income tax bracket in their retirement years then a tax-deductible contribution to the IRA or qualified retirement plan may be advantageous, even if the owner only currently derives 80% of the IRC 199A income tax deduction benefit. While all the contribution will be 100% taxable when it is distributed to the owner in his/her retirement years, that income may be taxed at possibly a lower income tax rate.
  3. QBI Deduction Limitations: The owner may never qualify for the IRC 199A QBI income tax deduction due to income limitations or some of the other IRC 199A qualification factors, such as the individual is a higher earning professional who owns a specified service trade or business, where the retirement plan contribution deduction, even if it lowered the professional’s reported taxable income, would still cause the individual to be disqualified from claiming the IRC 199A deduction, where reducing the owner’s current (high) taxable income would still be sound move with an income tax deductible retirement plan contribution.
  4. IRC 199A is Temporary: Finally, it is important to keep in mind that the IRC 199A QBI income tax deduction is only temporary. It is scheduled to sunset in 2025. It would not make much sense to hold off making an income tax deductible retirement plan contribution over the next six years until 2026 just to claim a temporary income tax deduction under IRC 199A, which can also  be limited by some of the other restrictions mentioned earlier.

Conclusion: The inter-play between the IRC 199A QBI income tax deduction and the income tax deduction for contributions to an IRA or qualified retirement plan is terribly confusing. There are no easy answers, or convenient ‘rules of thumb’ to apply. Rather, it is best to run projections on various contribution options in order to fully understand the impact on the size and availability of the IRC 199A QBI income tax deduction.