Many experts thought the combination of reduced income tax rates and new pass-through tax rules in the Tax Act of 2017 would provide a disincentive for small-business owners to offer retirement plans. In reality, the opposite may be true. Small-business owners with service-oriented businesses may find that retirement plans actually reduce taxable income.
Pass-Through Tax Rules
The 2017 tax reform legislation now allows pass-through entities (such as partnerships, S corporations and sole proprietorships) to deduct 20%of “qualified business income” (QBI) (in 2018-2025, unless Congress takes steps to extend the deduction). However, service businesses (including attorneys, accountants, doctors and financial advisors) are not entitled to the full benefit of the 20% deduction if the business owner’s taxable income exceeds certain threshold amounts.
The applicable threshold levels for 2018 are $315,500 (married filing jointly) or $157,500 (single filers), and the deduction is phased out for service business owners with income between the threshold levels plus $50,000 for individual filers or $100,000 for joint filers. This means that clients who own service businesses and have taxable income that exceeds $415,000 (married filing jointly) or $207,500 (single filers) will not receive the benefit of the new deduction.
The income limits that apply to certain small-business owners can provide a powerful incentive for these taxpayers to take steps to establish a retirement plan that accepts pretax contributions in order to reduce taxable income and take advantage of the new 20% QBI deduction in 2018.
Small-Business Retirement Plan Options
A SEP IRA can allow a small-business owner to reduce taxable income by up to $55,000 (or 25% of compensation) in 2018 (the same limits that apply to 401(k)s also apply here). Because contributions are not required to be made to the account every year, a small-business client could establish the plan primarily to take advantage of the QBI deduction in 2018-2025, and simply stop contributing (or reduce contributions) if the deduction is allowed to expire after 2025.
This type of plan can be particularly appealing to a business owner who has no employees (or who has only family members for employees) because while no contributions are required each year, if the employer contributes any amount to a SEP IRA during any given year, contributions to the accounts of all employees who have performed services for the employer during that year become mandatory (certain employees who are under 21, earn less than $600 during the year or have not worked for the employer for three of the five preceding years may be excluded from participation) and contributions must be uniform among eligible employees.
Any employer can establish a SEP IRA as long as that employer does not maintain any other retirement plan — there is no maximum number of employees, as is the case with SIMPLE IRAs. SEP IRAs are retirement savings accounts that only provide for employer contributions (employee contributions are not permitted).
Small business clients with a substantial number of employees, however, may find the 401(k) structure more appealing — these types of accounts do not carry an obligation that the employer contribute to each employees’ accounts, and allow the employer to contribute up to the same $55,000 cap in 2018. The primary disadvantage of these plans is the expense of administering the plan and the nondiscrimination testing that may be required of the employer (safe harbor designs can reduce this burden in certain circumstances).
For business owners with higher income levels, SEP IRAs and 401(k)s may prove insufficient to help these clients reduce their taxable income to take advantage of the QBI deduction. These clients may wish to establish a defined benefit plan, which can allow for much larger contributions to reduce higher income levels to below the applicable thresholds.
The disincentive to contribute to a retirement plan (from which distributions will eventually be taxed at the owner’s future ordinary income tax rate, which may be higher than under the new tax regime) might actually work in reverse for small-business owners in service businesses — and helping these clients choose the right type of plan can be central to maximizing the new 20 percent QBI deduction.
Also by Bloink and Byrnes:
- Pass-Through Tax Planning to Boost New QBI Deduction Value
- The Backdoor Roth IRA: Investing Rules of the Backroads
- Tax Reform Didn’t Kill All Roth Recharacterizations
– See previous coverage of small-business retirement planning in Advisor’s Journal.
– For in-depth analysis of SIMPLE IRAs, see Advisor’s Main Library.