As a business owner, it can be difficult to balance achieving short-term tax savings against long-term financial goals. For many, the goal is to grow your wealth in a manner that’s as tax-efficient as possible.
But doing so demands you navigate certain trade-offs. One of the primary decisions you’ll have to make is how to balance immediate, short-term tax reductions with investing in your retirement.
When it comes to the Qualified Business Income (QBI) deduction, this balancing act becomes even more challenging. On one hand, contributing to a retirement plan can significantly reduce taxable income; on the other, these contributions may lower your QBI deduction, minimizing the tax benefits you stand to realize.
Determining which path is best for you can be challenging, but in this guide, we’ll help you understand the basics of how the QBI deduction and retirement plan deductions interact with each other. We’ll explore what the QBI deduction is and how you can use it to reduce your taxable income. We’ll also share some of the common errors we see business owners make in this space and discuss how Revonary can help you make the best decision for your unique situation.
Understanding the QBI Deduction
The QBI deduction allows eligible business owners to deduct up to 20% of their qualified business income, providing a significant tax savings opportunity. There are a few important words in that sentence, specifically:
- Eligible Business Owners: to be eligible, you must own a pass-through business structured as a sole proprietorship, partnership, S corporation, or LLC. C corporation owners are not eligible.
- Up to 20%: Business owners in certain fields, defined by the IRS as Specified Service Trades or Businesses (SSTBs), see the deduction phase out when their income exceeds certain thresholds. If your business is service-based rather than product-based, it’s likely an SSTB. Examples of SSTBs include physician’s practices, law firms, and consulting businesses.
- Qualified Business Income: qualified business income is the net income earned from the pass-through business. This taxable income of the business does not include wages or guaranteed payments paid to the business owner, or investment income.
Once you understand these definitions, the way the QBI deduction works is relatively straightforward in some cases. If your business had net income of $100,000, the 20% QBI deduction means that you’ll be taxed as if the net income were $80,000.
However, not all businesses qualify for the full deduction. Limitations and thresholds come into play based on factors like income level and business type. If your income is above a certain level and you operate an SSTB, you may be fully excluded from the QBI deduction––and all the tax savings that come along with it.
That’s why holistic tax planning is essential to maximize the QBI deduction. Business owners must consider how other deductions and expenses, such as retirement plan contributions, impact their overall taxable income and QBI eligibility.
Exploring the Impact of Retirement Plan Contributions on QBI
Contributing to a tax-favored retirement plan, such as a SEP IRA, 401(k), or defined benefit plan, is a powerful way for business owners to reduce their taxable income while saving for the future. These contributions can also lower business taxable income, which directly impacts the QBI deduction. Depending on your situation, that can either be beneficial or not.
Here’s how it works:
Higher retirement plan contributions reduce the taxable income of the business. If you, through the business, contribute $50,000 to a qualified retirement plan, your taxable income is reduced by the same amount.
Lowering your taxable income means a smaller QBI deduction. Let’s say you’re a married business owner with $200,000 in net income. You could:
- Claim the 20% QBI deduction, and only be taxed on $160,000 of that business income.
OR
- Make a $50,000 retirement contribution, lowering your taxable income to $150,000. Then, you’d claim the QBI deduction, lowering your taxable income to $120,000 (Note: you’d still be taxed on the retirement income later in life when you start withdrawing it from your retirement account. The general idea is that you’d be taxed on it at lower rates since you typically earn less in retirement than in your working career).
Whether or not this is advantageous or not depends on your individual situation. Making retirement contributions means you lose some of the immediate tax savings from the QBI deduction. Plus, retirement contributions represent a cash outflow. However, if your income is above the phaseout thresholds, making retirement contributions that lower your taxable income can in fact make you eligible for a greater QBI deduction.
Consider the hypothetical example of an attorney (a business type classified as an SSTB) who has net business income above the phaseout thresholds. By contributing to a defined benefit plan, the attorney reduces their taxable income by that amount of their contribution, potentially making them eligible for the QBI deduction on that income.
The key here often lies in having your tax professional conduct break-even calculations to determine how you should balance retirement contributions against reaping the maximum benefit from the QBI deduction. It’s important to consider the situation holistically, balancing your retirement saving goals against the immediate tax benefits available to you today.
Plus, other strategies are available. Backdoor Roth IRAs are a good fit for business owners with high income and no pre-tax IRA balances, while the mega backdoor Roth strategy is well-suited to business owners with a flexible 401(k) plan that allows them to aggressively invest after-tax dollars in tax-advantaged Roth retirement accounts.
Clearly, this decision is complex, and there are several factors that business owners have to consider. Every taxpayer’s situation is unique, and there’s no one-size-fits-all approach. Consulting with a tax professional ensures that your strategy is tailored to your specific needs and goals.
Common Mistakes Business Owners Make
Navigating the interplay between QBI deductions and retirement contributions can be challenging, and mistakes are common. Here are a few to avoid:
- Misidentifying Business Type: Not understanding whether your business qualifies as an SSTB can lead to missed opportunities for tax savings.
- Focusing Solely on Tax Savings: Prioritizing tax savings without considering cash flow impacts can be short-sighted. Remember, QBI is a tax deduction that reduces the amount you’ll pay, while retirement contributions require an immediate cash outlay.
- Undervaluing Retirement Accounts: Failing to place adequate value on the long-term benefits of retirement savings can result in missed financial opportunities. Building wealth is a marathon, not a sprint, and it’s important business owners don’t overlook funding their retirement accounts.
- Neglecting Holistic Planning: Looking at deductions in isolation, rather than as part of a broader tax and financial strategy, can lead to suboptimal results. An experienced tax professional, like those on our team at Revonary, can help you navigate these issues holistically.
Balancing QBI deductions with retirement contributions is a nuanced process that requires careful consideration of tax savings, cash flow, and long-term planning. Business owners who approach this decision strategically can avoid these errors and instead achieve the best of both worlds: maximizing tax benefits while building a strong financial future.
How Revonary Helps Business Owners Explore the QBI-Retirement Trade-Off
At Revonary, we understand that every business owner’s tax profile is unique. That’s why we take a tailored approach to tax planning, evaluating each client’s individual circumstances to develop the best strategy.
We start by analyzing your business type and income level to identify whether you’re an SSTB or a qualified business. Then, using tax projections, we calculate multiple scenarios to compare the benefits of various retirement contribution levels versus QBI deductions. Finally, we’ll meet with you to discuss the pros and cons of each scenario, helping you make an informed decision that aligns with your short- and long-term financial goals.
We’re here to help you navigate these complex decisions with confidence. Contact us today to learn how we can help you develop a customized tax strategy that works for you.
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