Qualified retirement plans were a good deal before the December 2017 Tax Cuts and Jobs Act. For many professional firms, they’re now better than ever.
Here’s the new part: many owners of pass-through businesses like S corporations, LLCs and sole proprietors are eligible for a 20% deduction on Qualified Business Income (QBI), essentially non-W2 business income (profits).
For “specified service businesses”, i.e. most professional firms, the 20% deduction is limited in 2018 for owners with income of more than $315,000 (married) or $157,500 (single) [1]. It’s completely eliminated for owners with income of more than $415,000 (married) or $207,500 (single). If your income is below the threshold, you’re eligible for the entire 20% deduction. If your income is too high, retirement plan contributions can bring it down below the threshold. An excellent “Deduction-Reduction” article notes that retirement plan deductions aren’t a clear winner for every business owner, especially in light of the January 2019 QBI regulations. But at the right income levels, the combined effect of the retirement plan and QBI deductions can be astonishing.
Let’s take the example of Rachel, a 50 year old married partner in a successful LLC. Her share of the firm’s profits is $404,000. If she maximizes her 401(k) deferral and the firm maximizes her profit sharing contribution (total of $61,000 with catchup), her income has dropped just below $315,000. She’s entitled to the $61,000 deduction and, in addition, she can now deduct the entire 20% of QBI. The table below shows how it works:
| With 401(k)/PS Contribution | Without 401(k)/PS Contribution | |
| Preliminary taxable income (PTI) | ||
| Pass-through business income | $ 404,000 | $ 404,000 |
| Other income, e.g. W-2 or spouse | 24,000 | 24,000 |
| Capital gains | – | – |
| REIT dividends & public partnership income | – | – |
| Retirement plan deduction [2] | (61,000) | – |
| Self-employed health insurance deduction | (15,000) | (15,000) |
| Deduction for employer FICA tax | (13,371) | (13,371) |
| Standard deduction | (24,000) | (24,000) |
| Preliminary taxable income (PTI) | 314,629 | 375,629 |
| Qualified Business Income (QBI) | ||
| Pass-through business income | 404,000 | 404,000 |
| Retirement plan deduction [2] | (61,000) | – |
| Self-employed health insurance deduction | (15,000) | (15,000) |
| Deduction for employer FICA tax | (13,371) | (13,371) |
| Qualified Business Income (QBI) | 314,629 | 375,629 |
| Income for QBI deduction | ||
| Adjusted PTI: PTI less capital gains | 314,629 | 375,629 |
| QBI plus REITs & public partnership income | 314,629 | 375,629 |
| Smaller of the two | 314,629 | 375,629 |
| QBI deduction | ||
| Full deduction percentage | 20% | 20% |
| Adjusted % (phase-out) | 20.00% | 7.87% |
| Times income for QBI deduction | 62,926 | 29,562 |
| QBI deduction: limited to 20% of adjusted PTI | 62,926 | 29,562 |
| Taxable income after QBI deduction | 251,703 | 346,067 |
| Federal income tax [3] | 48,988 | 74,120 |
| Tax savings | $ 25,132 |
By contributing $61,000 to her own retirement account, Rachel has reduced her 2018 taxable income by $94,364 and her federal income tax by $25,132. And that doesn’t even include her savings in state & local taxes.
What if Rachel’s firm is even more successful, so that her share of the profits is $556,000? With the right demographics, it’s still possible to contribute enough to bring her income down to the $315,000 threshold. To do that she’ll need a cash balance plan, which works especially well for professional firms. Partners around age 50 can contribute up to $150,000 – in addition to the $61,000 401(k)/profit sharing contribution. Older partners can contribute more than that: up to $280,000 cash balance at age 62 – for a total contribution of $341,000 (!) with 401(k) and profit sharing.
The next table shows this scenario for Rachel:
| With Cash Balance and 401(k)/PS Contribution | Without Cash Balance and 401(k)/PS Contribution | |
| Preliminary taxable income (PTI) | ||
| Pass-through business income | $ 556,000 | $ 556,000 |
| Other income, e.g. W-2 or spouse | 24,000 | 24,000 |
| Capital gains | – | – |
| REIT dividends & public partnership income | – | – |
| Retirement plan deduction [2] | (211,000) | – |
| Self-employed health insurance deduction | (15,000) | (15,000) |
| Deduction for employer FICA tax | (15,406) | (15,406) |
| Standard deduction | (24,000) | (24,000) |
| Preliminary taxable income (PTI) | 314,594 | 525,594 |
| Qualified Business Income (QBI) | ||
| Pass-through business income | 556,000 | 556,000 |
| Retirement plan deduction [2] | (211,000) | – |
| Self-employed health insurance deduction | (15,000) | (15,000) |
| Deduction for employer FICA tax | (15,406) | (15,406) |
| Qualified Business Income (QBI) | 314,594 | 525,594 |
| Income for QBI deduction | ||
| Adjusted PTI: PTI less capital gains | 314,594 | 525,594 |
| QBI plus REITs & public partnership income | 314,594 | 525,594 |
| Smaller of the two | 314,594 | 525,594 |
| QBI deduction | ||
| Full deduction percentage | 20% | 20% |
| Adjusted % (phase-out) | 20.00% | 0.00% |
| Times income for QBI deduction | 62,919 | – |
| QBI deduction: limited to 20% of adjusted PTI | 62,919 | – |
| Taxable income after QBI deduction | 251,675 | 525,594 |
| Federal income tax [3] | 48,981 | 135,337 |
| Tax savings | $ 86,356 |
This time, Rachel has reduced her 2018 taxable income by $273,919 and her federal taxes by $86,356 by contributing $211,000 to her own retirement accounts. And that still doesn’t include her savings in state & local taxes.
Qualified retirement plans have always been a sweet deal for professional service firms. And they just got a lot sweeter. Just let us know if you’d like to take a look.
[1] It’s also limited to 50% of W2 pay in many cases. To simplify this example, we’ve chosen a partnership-taxed LLC and other income that happens to equal the standard deduction.
[2] Assuming the same non-owner retirement plan contributions in both columns. In real life, non-owner contributions are an important plan design component – but we’ve simplified them here.
[3] Simplified calculation ignoring AMT and non-standard deductions.
