By Adam Cmejla, CFP®
July 24, 2019
When I originally wrote about the 199A deduction, and what it meant to practice owners, a big caveat was that all of the strategies that were discussed were in theory only—we hadn’t gone through a tax season to see how the strategies actually worked in practice based on client adherence to advice and how everything “shook out” on the tax return.
Here’s a short recap on the 199A deduction: Practice owners, who have taxable income under the limits, are able to deduct 20 percent of qualified business income (QBI) on their personal tax return, thus reducing their tax bill even more. This has been an especially “welcomed” deduction for those ODs in high-tax states that saw a reduction in the amount of allowable itemized deductions due to the state and local tax (SALT) cap of $10,000.
Now having one tax season behind us, we’re able to analyze how the conceptual strategies actually played out with clients.
Here is one interesting “ripple effect” of the deduction, how it applies to retirement plan contributions within a practice and strategies you can use to help minimize your tax bill—now and in the future.
Contributions to Retirement Plans Are Beneficial–Up to a Point
Contributions to retirement plans may not be all they’re cracked up to be. This statement may sound blasphemous coming from a CFP® professional or any “traditional” financial/investment advisor.
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After all, most planners and advisors usually jump to the “put as much as you can into your retirement accounts every year” strategy, and they usually do this for a couple of reasons: (1) it’s how most advisors are paid (as a percentage of assets under management) and (2) the “ripple effect” of this decision wasn’t too far reaching—you put money into your plan, you deduct in the current tax year as an “expense” on your business return (thus deferring the tax liability to future years) the amount of the contribution, and that was the end of the strategy.
Except that with the new 199A deduction, combined with additional guidance from the U.S. Treasury, there are additional implications on whether or not making retirement plan contributions make sense and, if they do, how much you should contribute.
How 199A Plays Out
Let’s look at it through an example client. Dr. Smith is married and the sole owner of See Perfect Optometry, LLC. His LLC elects for S-corporation tax status, and thus he files an 1120S each year for his business return.
Assuming that Dr. Smith’s household taxable income is below the QBI thresholds for 2019 ($321,400), he is able to deduct 100 percent of all QBI on his tax return. If his QBI income is $100,000, then his deduction is the following:
$100,000 x 20% = $20,000
However, Dr. Smith knows that he won’t be able to retire off the sale of his practice alone and thus knows the importance of using his practice as a way to utilize other vehicles to save for retirement. Knowing this, he implemented a 401(k) profit-sharing plan in his practice about five years ago and has been making contributions ever since. He’s had an especially profitable year in the practice and his cost-of-living has gone down in his personal life as well.
The combination of these two factors leads him to believe that making a profit-sharing (PS) contribution would be in his best interest, so he decides to allocate $40,000 to a profit share.
On the surface, this looks great: an upfront deduction on $40,000 and the tax deferral on that amount. Except that by making that $40,000 contribution, he has directly reduced the QBI that flows through on his personal return by the same amount. Let’s look at the math again, now with the profit-sharing contribution figured into the equation:
($100,000 QBI – $40,000 PS contribution) = $60,000 QBI x 20% = $12,000.
By virtue of making this contribution, he hasn’t exactly gotten a dollar-for-dollar benefit by way of deductions:
Without PS contribution: $20k deduction
With PS contribution: $40k + 12k = $52k
$52k – 20k = $32k.
Thus, by making the profit sharing contribution of $40,000, the net increase in deductions is only $32,000! But that’s only the beginning…
“The rest of the story” occurs when Dr. Smith is in retirement and goes to make a distribution from the 100 percent tax deferred profit-sharing account. Guess how much of that $40,000 original amount is going to be taxable to him when he takes it out? If you said 100 percent, you are correct.
When you look at the math, it’s as if Dr. Smith made an $8,000 non-deductible contribution to his profit-sharing account, but unfortunately, will not get “credit” for that in his account, and thus, will pay taxes on the full $40,000 plus any additional growth!
(Side note: these numbers would be reduced even further if Dr. Smith had eligible team members in his practice that qualified for profit-sharing contributions. The example above was simply to illustrate the concept and would be applicable if Dr. Smith did not have any employees eligible).
What Are Other Options For Savings?
One of the first questions to be answered is whether or not Dr. Smith anticipates being in a lower, similar, or higher tax bracket in retirement.
If he anticipates being in a lower tax bracket, then he may still very well be served making the contribution, as the deduction today will have more of an impact than the future tax he will pay on the distribution.
For example, if he is currently paying a marginal/effective tax rate of 24 percent today, but anticipates, and is planning on, being in a 12 percent effective rate in retirement, then the deduction today carries a lot more value than would the taxes paid in the future.
If he is close to retirement and anticipates taking distributions from the account in the near future, it may be best to forego the contribution altogether and just have the assets available in a non-retirement brokerage account.
If he anticipates being in a similar, or worse, higher tax bracket later in life, then one of the best strategies he can consider is making “mega back-door” Roth contributions into his retirement plan. There are a number of factors to consider regarding mega-back-door Roth contributions. Your 401k plan must have specific language in the plan document to accept these contributions, so if it doesn’t, or you’re not sure how to make this happen, now is the time to make an inquiry to your TPA and/or plan administrator and work in tandem with your advisor(s) to see if this in your best interest.
As illustrated, and in keeping with the status quo of tax planning, no two situations are alike and the dynamics of both tax law and your circumstances are always changing. However, you’ve heard me say it before and I’ll say it again—the benefits of this type of planning cannot happen reactively. You must be proactive in taking action, and this is the time of year to begin determining strategies for the remainder of the year.
Adam Cmejla, CFP® is a CERTIFIED FINANCIAL PLANNERTM Practitioner and Founder of Integrated Planning & Wealth Management, LLC, an independent financial planning & investment management firm focused on working with optometrists to help them reach their full potential and achieve clarity and confidence in all aspects of life. For a number of free resources, visit https://integratedpwm.com/ebooks/ and check out the “20/20 Money Podcast” wherever you find your favorite podcasts to get more tips on making educated and informed financial and business decisions.