The Impact of Small Business Retirement Plans on QBI

May 22, 2023

The qualified business income deduction (QBI) can be a mystery to many small business owners and entrepreneurs. In a nutshell, this is a 20% deduction on qualified business income for self-employed professionals, S Corp owners, partnerships, and business owners. 

Something that many folks miss is that retirement plan contributions can significantly influence this deduction. This is why for many entrepreneurs, it can be important to maximize this deduction in alignment with your personal financial strategy, particularly when considering retirement contributions.

Understanding Retirement Account Tax Deductions

Let's start by unraveling how tax deductions work when you make pre-tax contributions to your retirement account.

When you deposit money into a traditional-style retirement account, the amount of your contribution is generally deducted from your taxable income at your marginal tax rate. Simply put, if you make a $20,000 contribution and your marginal tax rate is 24%, you can expect to save $4,800 in taxes for that year. Once the money is in the retirement account, it can grow without being taxed until you withdraw it.

At retirement age, the distributed funds are taxed at your future tax rate, which may be higher or lower—a good reason to consider diversifying your tax exposure.

However, here's where a common blind spot surfaces for business owners. The impact of your retirement plan contribution on the qualified business income (QBI) deduction means you might not receive the full deduction you expected.

That's right! Contributions to a business owner's retirement plan, such as a SEP IRA or Solo 401(k), do not qualify for the QBI deduction. In other words, when you make a deductible contribution to one of these plans, it can reduce the income that qualifies for the QBI deduction.

To understand how this works, let's look at a real-life scenario.

Taxes and Qualified Business Income 

Meet Amanda, a small business owner without employees who generates $150,000 annually in self-employment income. She is married to Chris, who earns $50,000 as a W2 employee of another company.

Since Amanda has self-employment income, she is responsible for paying self-employment taxes (Social Security and Medicare taxes). In her case, the self-employment tax amounts to $21,194.

As a consolation prize, Amanda can deduct half of the self-employment tax paid on federal taxes. This deduction equals $10,597. Considering the self-employment income and the deduction for half of the self-employment tax, we can determine Amanda's QBI deduction of $27,881.  Here's how it's calculated for this scenario: QBI = (Self-Employment Income - Half of Self-Employment Tax) x 20%.

As their total income runs through the tax brackets, we see that Amanda and Chris are in the 22% marginal tax bracket. Taking into account their combined income, their total tax amounts to $41,250. This includes $21,194 for self-employment tax and $20,056 for federal tax.

Contributing to a retirement plan

Let's break down a Scenario where Amanda contributes to a self-employed retirement plan.

Amanda’s goal this year is to invest $20,000 in a traditional (pre-tax) solo 401(k) to establish financial independence from her self-employment. We can proactively assess how this $20,000 contribution will impact Amanda's taxes.

In this scenario, the $20,000 solo 401(k) contribution reduces Amanda's federal tax liability by $3,520 (from $20,056 to $16,563). This reduction translates to paying fewer taxes, which is great! However, there's more to consider.

Although the $3,520 reduction seems significant, it only represents about 18% of the $20,000 contribution, while Amanda falls in the 22% marginal tax bracket. Why is there a discrepancy?

The $20,000 solo 401(k) contribution lowers Amanda's income for the QBI deduction. As a result, her tax bill is slightly higher than it would be with the full deduction. The reduction in federal tax is only ~18% instead of the expected 22%.

Another way to think of it is that she is getting 80% of the deduction on the $20,000 today, but will be taxed on 100% of it when she withdrawals from the 401(k)!

Because we were able to walk through this with Amanda, we can help her make informed decisions about her retirement contributions, considering both immediate tax advantages and potential long-term implications. 

Given this information, Here are some additional key considerations when navigating retirement contributions and QBI:

  • A reduction in QBI due to self-employed retirement contributions may not be ideal, but it can still be beneficial compared to not contributing at all.
  • Align your retirement contributions with your financial goals. While you may not receive the full deduction based on your marginal tax bracket today, your future effective tax rate could still be lower.
  • Avoid making decisions solely based on taxes. Prioritize what will benefit your personal finances first, and then optimize your planning strategies for tax-related purposes.
  • Keep in mind that traditional IRA deductions do not reduce QBI. If you don't plan to contribute more than the IRA limit (currently $6,500 for 2023), you may want to consider an IRA over a self-employment retirement account.
  • If a Roth option is available, it may be more advantageous than pre-tax contributions that only receive an 80% tax benefit. 
  • QBI has a phase in range. This example is geared toward those under the phase-in range. In or above the QBI phase-in range can make more sense for pre-tax contributions spending on the situation. 

When it comes to planning and maximizing the qualified business income deduction, it's crucial to assess your unique circumstances and consult with a financial or tax professional specializing in entrepreneurship. 

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