On December 22, 2017, the Tax Cuts and Jobs Act was signed into law, creating significant changes to the tax code effective for 2018. While the rules for deductions and contributions to retirement plans did not change under the new law, tax-deductible retirement plan contributions may help certain business owners take advantage of the new 20 percent deduction for pass-through income.
Employers with business entities taxed as sole proprietorships, partnerships and S corporations are eligible to use the pass-through income deduction. However, the 20 percent deduction is limited or excluded entirely if the taxpayer operates a business in certain service fields (e.g., health, law, accounting, consulting, performing arts, athletics, financial services and brokerage services).
For business owners who operate in a specified trade or business, the ability to take advantage of the pass through income deduction is phased out when their income exceeds $315,000 if married filing jointly or $157,500 for all other taxpayers. The deduction is eliminated entirely for tax payers whose income exceeds $415,000 if married filing jointly or $207,500 for the single filer.
Using Retirement Contributions to Reduce Taxable Income
For business owners in these specified services, the value of a tax-deductible contribution to a retirement plan can become even more valuable. It provides a tax deduction for income that is already subject to the highest tax brackets. In addition, the deduction can potentially reduce taxable income below the income limitations in order to take advantage of the pass-through deduction.
For example, consider a 51-year-old doctor with pass-through income who is married filing jointly and has earned an income of $500,000. Because she has income over $415,000 and her business is in the field of health, she cannot take advantage of the 20 percent deduction for pass-through income. However, if this doctor were to sponsor a 401(k) profit sharing plan and a cash balance pension plan, she could have tax-deductible contributions to her retirement plans as follows:
- $160,000 to a cash balance plan
- $24,500 to a 401(k) plan
- $16,500 to a profit sharing plan
These tax-deductible contributions total $201,000, reducing her earned income of $500,000 to a taxable income of $299,000. Now that she is under the income limit, she can apply the 20 percent deduction to pass-through income in addition to the standard deduction of $24,000 to further reduce her taxable income.
Other Retirement Plan Contribution Considerations for Business Owners
The amount an individual can contribute to a cash balance plan varies based on their age and income, increasing as the business owner ages.
If the business has employees, contributions to the employee retirement plans may also be required, ranging from five percent of compensation to 10 percent of compensation depending on the ages of the employees. These contributions are also tax deductible, and the tax deductions typically pay for the cost of the contributions.
Business owners with employees may also benefit from the ability to increase their own profit-sharing contribution up to a maximum of $36,500. Assuming the owner also makes 401(k) contributions, their total tax-deductible contribution to the 401(k) profit sharing plan can be as much as $61,000, in addition to the cash balance contribution.
If you would like to find out how retirement plan contributions could help you take advantage of the 20-percent deduction for pass-through income, please contact us.