07 Jun How the Qualified Business Income Deduction Supercharges OR Mitigates the Tax Benefits of Retirement Contributions
At the end of 2017 Congress passed the Tax Cuts and Jobs Act which included the new §199A. This section allows a deduction equal to 20% of your “qualified business income” or QBI. There are some pretty complex rules around this deduction and one aspect I’m focusing on today deals with the limitation that doctors face. §199A limits and eventually eliminates the 20% deduction on “specified service trade or business” income. Health fields are included on the list (if you receive a 1099-MISC or K-1 instead of or in addition to a W-2 then you’re self-employed).
As a self-employed doctor, once your taxable income gets above a certain amount, the 20% deduction begins to get reduced until you reach the income level where you get no deduction at all.
Mitigated Tax Benefits
This factors into the tax benefits of funding your retirement plans. When you make pre-tax contributions it reduces your taxable income AND your QBI on which the 20% deduction is calculated. This is an interesting interplay because one deduction is reducing another deduction. This has the effect of mitigating the tax benefit of your retirement contribution.
Here’s an example – Let’s say that before your retirement contributions your QBI is $250,000 and your 20% deduction is $50,000 and you’re not affected by the income phase-out.
If you contribute $50,000 to a pre-tax retirement account it brings your QBI down to $200,000 and your 20% deduction down to $40,000.
This means that you’re really only getting a $40,000 deduction for the $50,000 contribution because you lost $10,000 of the 20% deduction.
My example is pretty simple but Dr. Dahle over at the White Coat Investor wrote a pretty detailed post about this effect.
Supercharged Tax Benefits
I want to focus on another aspect of the relationship between the 20% deduction and your retirement plan contributions. Instead of mitigating the tax benefit, there are some scenarios where the 20% deduction can actually amplify the tax benefits of your retirement contributions.
Let’s take the example of a married physician with 2 children earning $465,000 of self-employment income. Her spouse doesn’t earn any money.
Without any retirement plan contributions, our friend does not get any 20% deduction. This means that by making pre-tax contributions our friend can go from getting no 20% deduction to getting some 20% deduction. This supercharges the tax benefit of your pre-tax retirement contributions.
I created a baseline scenario where our friend is making no retirement contributions then made 5 scenarios where she makes $25,000 more in pre-tax retirement contributions. In the first scenario she’s only contributing $25,000 but in the last she’s contributing $125,000.
There’s an added twist here with the Child Tax Credit. The Child Tax Credit also gets phased out when your income gets too high. By making more pre-tax retirement contributions you can qualify for more of the Child Tax Credit. A double benefit.
Here’s what I found –
A few quick notes about this chart –
- Tax Savings from Baseline savings of that scenario compared to the Baseline scenario
- Marginal Savings from Baseline means the taxes saved over the amount of pre-tax retirement contributions of that scenario
- Tax Savings from Prior Case means the taxes saved on the additional $25,000 of pre-tax retirement
- Marginal Tax Rate from Prior Case means the taxes saved on the additional $25,000 of pre-tax retirement over $25,000
You can get a lot of bang for your buck if you find yourself in this situation.
Everyone’s tax situation is different but some people are in a position to supercharge their pre-tax retirement contributions.
One strategy that takes this into account is having a 401(k) that allows the Mega Backdoor Roth strategy paired with a cash balance plan. You could contribute just enough pre-tax to get to the bottom of the phase-out range then switch to post-tax 401(k) contributions.
You don’t need to fund your retirement accounts during the tax year so you can actually optimize the pre and post tax contributions you make.