QBI deductions vs. 401(k) savings: What makes the most sense for small business owners?
Someone once said that only two things in life are guaranteed: death and taxes. Working in the financial services industry, we disagree. We think there are three things guaranteed in life: death, taxes, and change—the latter two of which often work hand-in-hand.
Chances are, unless you work as some type of accountant, tax professional, or financial advisor, you’ve been confused about tax laws at some point. The ever-changing rules and regulations surrounding taxes can be hard to keep up with, but Americans can help maximize their annual return (or minimize what they owe back) by being aware of new tax-related developments.
As such, thanks to the new Tax Reform, small business owners now have the chance to take advantage of a new tax benefit: the Qualified Business Income (QBI) deduction.
The Qualified Business Income deduction provides a 20 percent deduction on—you guessed it—qualified business income, subject to some limitations. The benefit of a 20 percent deduction on taxable income is clear, so it’s unsurprising that many business owners are wondering how to qualify and how to take full advantage of the new rule this year.
However, as is the case with most tax regulations, the QBI deduction is anything but clear, cut and dry. There are various limitations and stipulations built into the deduction—leaving many business owners unclear on whether or not they even qualify, how to maximize the tax advantage, and what options make the most sense…even after they’ve started reading about the new reform. And while we’ll cover the basics surrounding the QBI deduction, this stuff is complicated so we highly recommend business owners consult their CPA for guidance on their own scenario.
Now, let’s dive right in.
Why do we have the QBI deduction?
Every business entity is taxed as one of the following: C-Corporation, S-Corporation, Sole Proprietorship, or Partnership. C-Corporations are taxed at the business level, but the other three businesses, called “pass through entities,” are taxed at the personal level. The 2017 Tax Reform Act created one tax rate for C-Corporations, dropping the top corporate tax from 34 percent in 2017 to a flat 21 percent in 2018, but for pass through entities taxed at the personal level, the rate could be as high as 37 percent. The QBI deduction was designed to level the tax playing field for these pass through entities.
So, if you were a business owner, would you want your business profits taxed at 21 percent or 37 percent? We’re willing to bet you’d prefer the 21 percent option—which is exactly why Congress added the 20 percent QBI deduction to put pass through entities in a similar position tax-wise as C-Corporations. Or to put it another way, the top personal tax rate of 37 percent for pass through entities would drop to 29.6 percent (37 percent reduced by 20 percent) with the new QBI deduction.
The value of this deduction is obvious: tax savings. And although the new deduction will certainly be powerful in helping small business owners reduce their overall tax liability, the regulations also come with a price—uncertainty and confusion.
And as we all know, uncertainty and confusion often lead to rash decisions—often ones that haven’t been fully vetted or thought-out. As it relates to the QBI deduction, some business owners have decided that 401(k) plans are now dramatically less valuable, when in reality, they’re just as valuable as they’ve ever been. But more on that in a minute. Let’s get back to the basics for now.
Qualifying for the QBI deduction
Now that we know the “why,” what is the “how” of the QBI deduction?
After confirming the business is a pass through entity, the next step is to have income from a “Qualified Trade or Business.” This is basically any trade or business with a major exception: it does not include “specified service trades or businesses” (SSTB). That exclusion disqualifies just about any business where the principal assets of the trade or business are the reputation and skill of the individual. Think: the fields of health, law, accounting, performing arts, and financial services.
But there is an exception to the exception for SSTB.
A SSTB can still be a Qualified Trade or Business for the deduction if the taxable income of the individual owning the SSTB is below a specified amount. For 2019, that amount is $421,400 for joint filers and $210,700 for single filers. So, if you operate an SSTB and your taxable income exceeds the specified amount, you will not be eligible for any portion of the deduction unless you effectively lower your taxable income. If you are above the income thresholds, you aren’t destined to miss out on the deduction entirely. There are multiple strategies to reduce your taxable income for the year—our favorite of which includes contributing to a small business 401(k) plan.
We should note that the QBI deduction is subject to phase-outs, meaning the SSTB taxpayer would not get the full 20 percent QBI deduction unless taxable income is below $321,400 for joint filers and $160,700 for single filers. Taxable income between those amounts results in a reduction in the QBI, so for example, if taxable income is $371,400 for a joint filer (halfway between $321,400 and $421,400), only 50 percent of Qualified Business Income can be counted for the 20 percent deduction.
The QBI deduction kaleidoscope
Have you ever looked through a kaleidoscope—seeing one pattern when you turn it one way and another pattern when you turn it another way? Well, the QBI deduction is a lot like that; turning the QBI deduction kaleidoscope one way gets you one deduction number while turning it another way gets you a different number. But which number do you use for the QBI Deduction? The smaller one.
The first number you need to find in your QBI deduction kaleidoscope is the “combined qualified business income amount.” This will be the lesser of 20 percent of the QBI or the W-2 wage limitation amount. The W-2 wage limitation amount is the greater of two other numbers, but in most cases it will be 50 percent of the W-2 wages with respect to the business. The other calculation only comes into play if you have unadjusted basis in certain acquisition property.
Once you have the combined qualified business income amount (lesser of 20 percent of QBI or 50 percent of W-2 wages), you twist the kaleidoscope in the other direction to get the second deduction number. This will be 20 percent of the amount taxed as ordinary income (adjusted for net capital gain). Now all that is left to do is to compare the two number and use the smaller number for your QBI deduction.
What happens if your business doesn’t have any W-2 wages? Unfortunately, that means no QBI deduction—50 percent of zero W-2 wages is zero.
But wait—there is still hope. You do not have to apply the 50 percent W-2 wages limitation if the individual’s taxable income is below a specified amount. To reiterate, that amount for 2019 is $421,400 for joint filers and $210,700 for single filers. And just like the calculation to be eligible for the QBI deduction for an SSTB taxpayer, you will not get the full 20 percent QBI deduction unless taxable income is below $321,400 for joint filers and $160,700 for single filers. Taxable income between those amounts results in a reduction in the QBI deduction.
Let’s put this all together with an example: you earn $150,000 as a sole proprietor designing landscapes. While you have no W-2 wages associated with the business, your spouse makes $100,000 in a job earning W-2 wages. You use the 2019 Standard Deduction of $24,400, so your joint taxable income is lowered to $225,600. Your business is a specified service trade or business, so you think you aren’t eligible for the QBI deduction—but because your taxable income is below $421,400, you meet the eligibility exception for a service trade. And because it is below the threshold amount of $321,400, you can get the full QBI deduction.
But your business has no W-2 wages, so does your QBI deduction amount to zero?
Once again, because your taxable income is below the income thresholds for joint filers of $421,400 and $321,400, you do not have to use the W-2 wages limitation rule or reduce the QBI deduction amount. So your QBI deduction allowance is the lesser of 20 percent of QBI (20% X $150,000 = $30,000) or 20 percent of taxable income (20% x $225,600 = $45,120). In this scenario, you can utilize the QBI deduction to deduct $30,000 from your taxable income.
How do 401(k) savings come into the QBI conversation?
The new deduction created many opportunities for small business owners to strategize on how to max out their tax benefits for the year; it also inadvertently created confusion on where retirement savings come into play with all of this. We alluded to it earlier, but the new QBI deduction may cause retirement savings to take a hit if business owners aren’t careful. But how?
Let’s start simple. Hang in there.
Qualified retirement plan contributions are deducted against business income, and the 20 percent QBI deduction is not available to income that’s been deferred into a qualified retirement plan. As such, many business owners who are not above the income thresholds for the QBI deduction are considering bypassing 401(k) savings in favor of the deduction. Why? Because those contributions lower taxable income, thus lowering the amount of income that qualifies for that 20 percent deduction.
Business owners who are above the income threshold don’t necessarily need to worry about this either/or type situation; they can utilize 401(k) savings to lower their taxable income into the QBI deduction income threshold range, then utilize tax advantages in both areas. But for owners who do not make more than the QBI deduction income threshold, there are decisions to be made.
Both 401(k) savings and the QBI deduction offer tax advantages, but in different ways. With the QBI deduction, business owners will pay the tax up-front while 401(k) contributions are not taxed until they are distributed, potentially years and years down the road. Which advantage is greater will depend heavily on the business owner’s specific situation.
For many business owners, the decision becomes: Tax deferral in a 401(k) vs. 20 percent QBI deduction—which makes the most sense? Let’s look at a couple of scenarios to illustrate how this head-to-head plays out.
A business owner has $35,000 in qualified business income and has to decide whether to save the money inside a 401(k) or save it outside of a qualified plan (like in personal savings) to take advantage of the QBI deduction. Let’s say the business owner is 40 years old and wants to retire at 65, so the money he is saving now will have 25 years to grow. Would this particular business owner earn better tax advantages using 401(k) or the QBI deduction?
In this scenario, the business owner actually comes out over $10,000 ahead by utilizing 401(k) savings over the QBI deduction. However, that’s not always the case. Let’s take a look at another scenario.
In this scenario, our business owner has $56,000 available that he can either contribute to a 401(k) or save in personal savings and is 10 years away from retirement. This business owner is a high-earner, with his income falling into the 37 percent tax bracket. How would this owner fare in the 401(k) vs. QBI calculation?
As you can see, this business owner actually came out slightly ahead using the QBI deduction. Each situation is unique when determining whether 401(k) savings or the QBI deduction makes the most sense from a tax advantage perspective, so the outcome will look different for your own scenario. In general, the lower your tax income bracket is and the longer the amount of time you have to save, the better off you’ll be with 401(k) savings. But it’s vitally important to talk to your CPA or a trusted tax professional to determine which strategy is best for your individual situation.
Advantages of using 401(k) savings over the QBI deduction
All complicated math aside, there are certain benefits of utilizing a 401(k) plan to house your savings. For starters, 401(k) savings are creditor-protected and anti-alienation protected, which means if your business happens to go under, your 401(k) savings are protected. Outside assets, like money in personal savings, are not. So while you may come out ahead with the tax advantages of the QBI deduction, you run the risk of losing your savings if you file for bankruptcy or the business goes under by not storing savings in a 401(k) plan.
Plus, the key incentives of sponsoring a 401(k) plan—whether it’s an owner-only solo 401(k) or a traditional employer-sponsored 401(k)—have not changed. Small businesses with a 401(k) enjoy:
Accelerated tax-deferred savings
Protected financial assets in the event of bankruptcy or lawsuit
Tax deductions for employee contributions and plan-related expenses
Retirement savings for the business owner
Increased financial wellness benefits for employees
Additional benefit to help attract and retain talented employees in a competitive labor market
Clearly, retirement plans provide many benefits to small business owners—in terms of tax advantages, saving opportunities, talent acquisition, retention efforts, etc. And since there are many affordable plans out there for even the smallest of companies, business owners may want to consider implementing a 401(k) plan regardless. For more information about the benefits of a small business 401(k) plan, contact one of our retirement specialists today: 800.236.7400, option 1.
This stuff is complicated, and you'll likely need more guidance on the rules and regulations surrounding Qualified Business Income deductions. For more information about the Tax Reform and Section 199A QBI deductions, please review the IRS's guide, available here, or speak with your CPA or tax professional.