Using Retirement Contributions to Maximize Your 199A Deduction Before it Disappears

The 2017 tax reform legislation fundamentally changed the tax treatment of pass-through business entities through the enactment of Section 199A.  The 20% deduction for qualified business income (QBI) can greatly reduce tax liability for the owners of partnerships, S corps and other pass-through entities.  That said, the deduction isn’t available to all businesses.  Income restrictions serve to limit the availability of the deduction for higher-earning pass-throughs who are classified as service businesses.  There are steps that taxpayers can take to maximize the value of the QBI deduction—and many taxpayers may be forgetting that Section 199A is set to expire entirely after 2025 if Congress does not legislate an extension.  Taxpayers who are interested in maximizing the QBI deduction while simultaneously funding their retirements should act quickly to take advantage of this potentially limited deduction.

Limitations on the QBI Deduction

As clients now well know, the 2017 tax reform legislation allows pass-through entities to deduct 20 percent of “qualified business income” (QBI) (in 2018 to 2025).  Despite this, entities that are classified as “service businesses” (including attorneys, accountants, doctors, financial advisors and certain other service-related professionals) are not entitled to the full benefit of the deduction if the business owner’s taxable income exceeds certain threshold amounts.

The applicable threshold levels for 2024 are $383,900 (married filing jointly) or $191,950 (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 $483,900 (married filing jointly) or $241,950 (single filers) will not receive the benefit of the new deduction.

Because the QBI deduction is so valuable, entities that are classified as service businesses should aim to reduce taxable income to below the applicable thresholds if possible.  Of course, for many taxpayers, that can be a challenge.  Retirement plans can play a significant role in allowing business owners to maximize the value of the QBI deduction.

Retirement Plan Options for Reducing Taxable Income

Many business owners already have a 401(k) plan or SEP IRA program in place.  Those clients should be reminded to take advantage of expanded contribution limits for employers.  For 2024, employers can contribute up to $69,000 to their own retirement plan, assuming they have the income to support the contribution.  Taxpayers who are at least 50 years old should also take advantage of their catch-up contribution to 401(k) plans to increase their contribution to $76,500 in 2024.

For clients who have not already established a retirement plan, the SEP IRA option may be most appealing if the business has no employees (or few employees).  if the employer contributes any amount for any given year, they must make uniform contributions to the accounts of all employees for that year.

Because contributions are not required to be made to a SEP every year, a small business client could establish the plan primarily to take advantage of the QBI deduction.  If the deduction is allowed to expire, the employer could reevaluate its SEP contributions.

However, clients with more employees may be more attracted to a traditional 401(k) plan, where employer contributions are not mandatory.

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 or cash balance plan, which can allow for much larger contributions to reduce higher income levels to below the applicable thresholds.

Taxpayers who must reduce their taxable income by more substantial amounts may wish to consider cash balance plans and other types of defined benefit plans.  Cash balance plans are more complicated to administer but do generate large deductions from taxable income.  The employer will need an actuary to compute the level of contributions that may be made.

Cash balance plans provide for a guaranteed benefit level at retirement.  Like defined contribution plans, the cash balance plan is funded annually via fixed contributions.  The plan sponsor does bear the risk and responsibility for funding the plan.  However, the benefits can be significant, especially for businesses with few employees.

Contribution levels are based on age.  For 2024, the maximum contribution for a 60-year old is $318,000.  A 70-year old can contribute as much as $409,000.

Conclusion

By now, the QBI deduction is nothing new.  That said, business clients may be overlooking valuable tax savings if their circumstances have changed since Section 199A became law.  Those clients who can reduce their taxable income to below the threshold levels may wish to act before the deduction is set to expire to both proactively fund their retirement while benefitting from the QBI deduction.

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