QBI deduction & self employed retirement savings

[CoffeeR]

One of the benefits of the new tax law(s) is that self employed income is subject to a new 20% QBI deduction (with caveats if its over $315K for a married person). Still, I do not hit that limit and I have self-employment income. I also contribute the max I can to a SEP or similar retirement account.

It turns out that the 20% QBI deduction makes retirement contributions less desirable since you loose the 20% deduction on money going to the retirement account and when you withdraw the money you get taxed on the full amount you withdraw. I suspect everyone except me understood this... I just clued in.

Has anybody here thought through how this impacts retirement savings for self-employed individuals or more specifically for their own case? Clearly loosing the 20% QBI deduction for retirement savings is a negative, but how much? My gut tells me it is still (probably) worth moving self-employment income into pre-tax retirement accounts when you are young, but the older you are the more the loss of the QBI deduction will negatively impact the benefit to saving in a self-employment retirement account (as opposed to saving the money in a taxable account).

I'm not sure I am looking for a definite answer. I am just curios how others may have processed this and to what conclusions they have come. Have MMM members modified their self-employment retirement strategies due to the new tax laws and the loss of the QBI deduction on self-employment retirement savings?

[Slow&Steady]

I am very uneducated in this area right now, but learning. We haven't done our taxes yet this year and don't currently plan to open a self employed retirement savings account until next year.

Doesn't everything you contribute to the self employed retirement account still decrease your taxable income and the 20% QBI is on taxable income.  So if you do this right you could potentially lower yourself down by a tax bracket or two?

I get that you will pay taxes on what you withdraw in the future but I guess I just assume we would hopefully be in a similar or lower tax bracket in retirement, without needing the 20% QBI deduction.

If that doesn't make sense, I am extremely open to understand this better.

[terran]

Don't feel bad. No one thought retirement plan contributions (or 1/2 self employment tax deduction, etc) reduced QBI until the IRS released updated information in mid January. Tax software companies are still catching up.

I'll likely consider moving my Solo 401(k) somewhere that allows Roth contributions and make at least some of my contribution Roth.

Remember that you should still be comparing marginal rate now vs expected marginal rate at retirement, this new information just makes your QBI adjusted marginal savings for self employed retirement plan deductions lower than your normal bracket would indicate. So for example, if you're currently in the 22% then making a tax deferred self employed retirement plan election will save you 22%*(1-20%) = 17.6%, which is still better than the 12% bracket or the 15% bracket if we revert to that, but not better if you expect to be in the 22% bracket in retirement. Similarly, if you're the 12% then you'd save 9.6% by contributing, so you'd only want to contribute if you expect to withdraw in the standard deduction, although withdrawing in the 10% bracket would only be a little worse.

Don't forget to add in your state bracket too if you plan to retire to a lower/no tax state.

[CoffeeR]

You never lost the 20% deduction on your retirement contributions, because it was built into the tax law. It was never there to begin with.

I am not sure I understand this statement. For self-employment income I move into a taxable account, 80% is taxed at my tax-rate and of-course taxed for the life of the investment (capital gains, dividends, etc.). Any self-employment income I move into a retirement account is not (initially) taxed at all, but at withdrawal 100% of the amount is taxed.

So, ignoring the gains, say you want contribute $20K to self-employment retirement account, you pay no taxes, but when you withdraw you pay taxes on the $20K. If you, instead move it into a taxable account, you pay taxes on $16K ($20K - 20%), but then you are done with taxes on that money (again I'm talking about the gains on the $20K). It is not clear the former is always beneficial over the latter.

Ofcourse, gains and shifting tax brackets complicate the calculation. That is why I am asking what people here are doing. Maybe most are simply ignoring the QBI issue.

[CoffeeR]

Don't feel bad. No one thought retirement plan contributions (or 1/2 self employment tax deduction, etc) reduced QBI until the IRS released updated information in mid January. Tax software companies are still catching up.

Thanks. I'll try to feel less stupid. I am aware that changes of marginal tax brackets when retired make a difference in the calculation. The idea of a Roth self-employment account occurred to me as well since that (I think) mitigates some of the problem, but it will force me to open another account. Sigh.

I am still pondering the question since I am only now beginning to understand it. I am trying to evaluate for my own case (given my age and time horizon), if contributing self-employment income to a retirement account still make sense. This is not a matter of saving, it is just a matter of what vehicle I use to do this.

[Laserjet3051]

This seems to be a big deal, though for the life of me, no matter how many times I read the Kitces analysis, I cannot wrap my head around his central thesis/conclusion. In particular, as an S-corp, my ER SEP=IRA or ER solo401K contributions have always been deducted as a business expense before profit flows through, in this case now to QBI. Like in years prior, my contributions now are just as pre-tax as they were historically.  For s-corps, profit has always been reduced by ER IRA/401K contributions, the new QBI calculations dont seem to change this, though it may be different for sole props.

[CoffeeR]

This seems to be a big deal, though for the life of me, no matter how many times I read the Kitces analysis, I cannot wrap my head around his central thesis/conclusion.

Thanks for the comment. It led me to this PDF:

https://www.kitces.com/wp-content/uploads/2019/02/Will-The-Deductibility-Of-Retirement-Plan-Contributions-Be-Impacted-By-The-QBI-Rules-2018.pdf

The question confirms what I suspected though it appears to be even more complicated than I thought. It is not yet clear to me what the best course of action is (for me).

[SeattleCPA]

FWIW, I think the point Jeffrey Levine makes in the referenced article is a really good one.

And to simplify, if you have business income and make a $10,000 contribution to a SEP, you don't decrease your taxable income by $10,000 but only by $8,000. (This is because of Section 199A deduction.)

And then the problem is, when you later withdraw the $10,000 you'll pay taxes on the $10,000.

Levine suggests one approach which is to emphasize Roth accounts. And I've thought and wrote a while back about that too. My idea was use the deduction created by a large Section 199A to "shelter" a big Roth conversion:

https://www.physicianonfire.com/tax-free-roth-conversions/

One other thought: I think you need to do the math on this. No easy rule of thumb.

[GetSmart]

But the retirement accounts are an 'above the line' deduction.  So if you are looking to reduce your AGI for health care subsidies that would take priority right now, no ?  That's the way I am looking at it at least.  Although all that would change if health care subsidies are no longer within reach ( if AGI increases beyond the threshold).

[feelingroovy]

I'm not sure I am following entirely, even after reading the Kitses article and the flowchart.

Does this only apply if you are either a sole proprietor/partnership or to the employer-side contribution for a sole member of an S Corp?

I am a sole member of an S Corp and my employee side contributions come out of my W-2 income. So I'm guessing this only affects the company match?

[oldmannickels]

I'm not sure I am following entirely, even after reading the Kitses article and the flowchart.

Does this only apply if you are either a sole proprietor/partnership or to the employer-side contribution for a sole member of an S Corp?

I am a sole member of an S Corp and my employee side contributions come out of my W-2 income. So I'm guessing this only affects the company match?

In this situation you could conceivably lower your salary and not make those employee side contributions. This would lower salary, increase income and increase QBI deduction.

[dandarc]

If I'm reading all this right, when making retirement roth vs. traditional decisions when you're QBI eligible, you must remember that 20% is deductible whether you make the contribution or not. Effectively, your marginal tax rate is 80% of the base-value you'd use if you can't take the QBI deduction.

Example:
For 2019, we'll likely be in the 22% federal bracket, with our QBI deduction being limited by taxable income, so making traditional retirement contributions saves us 17.6% on federal taxes. If we were to do a Roth conversion, it would cost us 17.6% and not 22% because the QBI deduction would go up by 20% of the income this generated.

On a standard retirement withdrawal though, we will pay the full 22% if we're in the same bracket. 17.6% < 22%, so we should favor Roth contributions. But we're saving a large chunk of our income right now - isn't it likely we'll be in the 12% bracket or lower when withdrawing? Then we should go traditional.

Still have to do your own math and make an educated guess on future marginal tax rate, but remember that your marginal rate today is "less than advertised" if you're QBI deduction eligible.

[feelingroovy]

I'm not sure I am following entirely, even after reading the Kitses article and the flowchart.

Does this only apply if you are either a sole proprietor/partnership or to the employer-side contribution for a sole member of an S Corp?

I am a sole member of an S Corp and my employee side contributions come out of my W-2 income. So I'm guessing this only affects the company match?

In this situation you could conceivably lower your salary and not make those employee side contributions. This would lower salary, increase income and increase QBI deduction.

Yeah, conceivably. Realistically, I can't really lower salary as the IRS looks down on that practice even before this new tax law. I've been careful to set my salary at a reasonable level for my field in my area.

If I am understanding this correctly, I don't think this will affect me a lot. I have a Simple IRA, not a solo 401k as I have employees. So my company side of my contribution is just a few thousand. Doesn't seem worth taking on the paperwork cost of setting up a 401k so I can do Roth contributions.

So to me it matters which part of the contribution lowers QBI: both employee and employer sides of the owner's contribution or just employer side?

[Laserjet3051]

I'm not sure I am following entirely, even after reading the Kitses article and the flowchart.

Does this only apply if you are either a sole proprietor/partnership or to the employer-side contribution for a sole member of an S Corp?

I am a sole member of an S Corp and my employee side contributions come out of my W-2 income. So I'm guessing this only affects the company match?

In this situation you could conceivably lower your salary and not make those employee side contributions. This would lower salary, increase income and increase QBI deduction.

Yeah, conceivably. Realistically, I can't really lower salary as the IRS looks down on that practice even before this new tax law. I've been careful to set my salary at a reasonable level for my field in my area.

If I am understanding this correctly, I don't think this will affect me a lot. I have a Simple IRA, not a solo 401k as I have employees. So my company side of my contribution is just a few thousand. Doesn't seem worth taking on the paperwork cost of setting up a 401k so I can do Roth contributions.

So to me it matters which part of the contribution lowers QBI: both employee and employer sides of the owner's contribution or just employer side?

My understanding is that both lower QBI as both ER and EE retirement contributions (for an s-corp) are considered company expenses (ER is a fringe benefit expense, and EE contributions are part of the employee wage expense).

[SeattleCPA]

I'm not sure I am following entirely, even after reading the Kitses article and the flowchart.

Does this only apply if you are either a sole proprietor/partnership or to the employer-side contribution for a sole member of an S Corp?

I am a sole member of an S Corp and my employee side contributions come out of my W-2 income. So I'm guessing this only affects the company match?

In this situation you could conceivably lower your salary and not make those employee side contributions. This would lower salary, increase income and increase QBI deduction.

Yeah, conceivably. Realistically, I can't really lower salary as the IRS looks down on that practice even before this new tax law. I've been careful to set my salary at a reasonable level for my field in my area.

If I am understanding this correctly, I don't think this will affect me a lot. I have a Simple IRA, not a solo 401k as I have employees. So my company side of my contribution is just a few thousand. Doesn't seem worth taking on the paperwork cost of setting up a 401k so I can do Roth contributions.

So to me it matters which part of the contribution lowers QBI: both employee and employer sides of the owner's contribution or just employer side?

My understanding is that both lower QBI as both ER and EE retirement contributions (for an s-corp) are considered company expenses (ER is a fringe benefit expense, and EE contributions are part of the employee wage expense).

That's how I read the final regs... and I think most people reach same conclusion. One thing that one needs to be careful about is not double-counting the adjustments though... As @Laserjet3051  points out, both employee and employee pension contributions appear on an S corporation tax return as deductions so they already lower QBI. With a sole proprietorship or partnership, though, the equivalent adjustments appear on 1040 return and so need to be adjusted there.

This blog post isn't really written for casual readers, but it might be helpful if one wants to look at the actual regulation language:

https://evergreensmallbusiness.com/section-199a-qualified-business-income-adjustments/