Making money is a fundamental goal for every entrepreneur and small business owner. While pursuing a passion and the independence that comes with running your show are also vital motivators, the viability of any venture ultimately depends on its financial health. Generating revenue is part of the profit equation and often gets most of the attention; the other essential component is managing expenses to keep as much of what you bring in as possible. If your business is a sole proprietorship, a partnership, or an LLC, you pay personal taxes on your business's profits. Reducing what you owe in taxes (legally) is a way to keep more of those profits for yourself.
One strategy for reducing your tax burden as a small business owner is to use the Qualified Business Income (QBI) deduction. In this brief article, we discuss the QBI deduction and why it sometimes makes sense to take advantage of it. We say “sometimes” because, given how the QBI deduction interacts with contributions you may want to make to your retirement savings, you may decide that not using it is your best strategy.
Understanding the Qualified Business Income Deduction
The QBI deduction allows most entrepreneurs, small business owners, and other self-employed individuals to deduct up to 20% of their qualified business income from the taxable income they report to the IRS for the year. For example, if your business generates $200,000 in taxable income, the QBI deduction could reduce this by up to $40,000, lowering your taxable income to $160,000, meaningfully decreasing your tax liability.
Introduced by the Tax Cuts and Jobs Act of 2017, the QBI deduction (Section 199A) is designed for owners of pass-through businesses, such as sole proprietorships, partnerships, LLCs, and S-corporations. These businesses pass their income directly to their owners, who report it on their tax returns.
However, not all pass-through income qualifies. For example, income from specified service trades or businesses (SSTBs)—which rely on the skills or reputation of their owners or employees, like medical practices, law firms, and accounting firms—may be ineligible for the QBI deduction once the owner’s income surpasses certain thresholds.
While the QBI deduction offers significant tax advantages, how it interacts with contributions to tax-advantaged retirement accounts can be confusing. It’s a common misconception that contributions to retirement plans directly reduce the QBI deduction. In reality, individual retirement contributions (like those to a traditional 401(k) or SEP-IRA) may affect the QBI indirectly by reducing the owner’s compensation from the business, since QBI is calculated based on business income after payroll. This is why the type of retirement plan you are contributing to may have a big impact.
Interplay Between QBI Deduction and Retirement Contributions
Deciding whether to contribute to a retirement account or maximize your QBI deduction depends on various factors:
Roth vs. pre-tax retirement plans through your business: Contributions made to a retirement account through your company reduce the taxable income the business generates for you and thus indirectly affect your QBI deduction. In contrast, Roth contributions are made with after-tax dollars and do not reduce current taxable income, preserving your QBI deduction's full potential.
Different retirement accounts have different contribution limits: The maximum amount an individual can contribute to a Traditional (or Roth) IRA in 2024 is just $7,000. That’s less than half the maximum contribution of $16,000 allowed for SIMPLE IRAs and SIMPLE 401(k)s and less than one-third of the $23,000 you can contribute to a 401(k), 403(b), or similar accounts. SEP-IRA contributions can be as high as $69,000, subject to limits based on the income the business generates. However, contributions to a Traditional IRA do not affect the QBI deduction, so it could make sense to contribute a smaller amount for retirement using a Traditional IRA outside of your business while preserving your QBI deduction. Let’s use an example:
Hypothetical Scenario
Assume you own an S-corporation and are single (for the purpose of filing taxes). You draw a reasonable salary from the business and also receive pass-through income. Your total income from the company (including salary and distributions) amounts to $160,000 annually. You're considering whether to contribute to a Roth 401(k) or a traditional 401(k) and how this choice impacts your QBI deduction.
Options:
Contribute to a Traditional 401(k)
Contribute to a Roth 401(k)
Maximize QBI Deduction
Financial Details:
Total Income from the Business: $160,000
Standard Deduction for a Single Filer in 2023: $13,850 (for simplicity, we assume no other deductions)
No Retirement Plan Contribution:
Taxable Income before the QBI Deduction: $160,000 - $13,850 = $146,150
QBI Deduction: 20% of $146,150 = $29,230
Taxable Income after QBI Deduction: $146,150 - $29,230 = $116,920
A $20,000 Traditional 401(k) Contribution:
Taxable Income before QBI Deduction: $160,000 - $20,000 - $13,850 = $126,150
QBI Deduction: 20% of $126,150 = $25,230
Taxable Income after QBI Deduction: $126,150 - $25,230 = $100,920
A $20,000 Roth 401(k) Contribution:
Taxable Income before QBI Deduction: $160,000 - $13,850 = $146,150 (Roth contributions do not reduce taxable income)
QBI Deduction: 20% of $146,150 = $29,230
Taxable Income after QBI Deduction: $146,150 - $29,230 = $116,920
Analysis and Strategic Considerations:
Traditional 401(k): Contributions lower your taxable and QBI-eligible income, reducing your current taxable income and the QBI deduction. This option is beneficial if current tax savings are a priority and you anticipate being in a lower tax bracket in retirement.
Roth 401(k): Contributions do not reduce taxable income now, meaning your income remains higher in the current year, but you benefit from the larger QBI deduction. The advantage here is that withdrawals in retirement are tax-free, which is beneficial if you expect higher tax rates in the future or prefer tax diversification in your retirement assets.
Maximize the QBI Deduction: If avoiding immediate taxes is not a priority and you anticipate higher future tax rates, contributing to the Roth 401(k) while taking full advantage of the QBI deduction is an attractive strategy. This choice maximizes your QBI deduction now and secures tax-free income for the future.
Future Tax Considerations: The choice between traditional pre-tax retirement account contributions and Roth post-tax contributions can hinge on your anticipated future tax situation. If you expect to be in a higher tax bracket in retirement than you are today, Roth contributions may be more beneficial despite not offering a tax break right now.
Expiry of the QBI Deduction: With the QBI deduction set to expire at the end of 2025 unless Congress acts to extend it, optimizing your tax strategy while you can is crucial.
Wrapping it up
There’s no easy answer to the question, “which should I choose – the QBI deduction or tax-deferred retirement contributions?” It depends on how much you make, how your business is structured, how much you have saved for retirement, how close you are to retiring, your current tax bracket, and how much income you are likely to generate after retirement. Bottom Line: The QBI deduction can offer eligible small business owners. valuable tax benefits. However, given its complexities and interactions with retirement plans, it is not always the best choice.
If you are a small business owner or entrepreneur and have yet to explore these options, we strongly recommend you consult a financial advisor or tax professional to determine a strategy that best suits your specific circumstances and financial goals. We invite you to contact us to discuss this and other opportunities to reduce your tax burden and optimize how your financial life serves your needs, goals, and values.
Disclosure: Advisory Services are offered through Gold Medal Waters, a Registered Investment Advisor. This post and material presented are for informational and illustrative purposes only, and do not constitute investment advice and is not intended as an endorsement of any specific investment. As is such, this material is not client-specific, we make adjustments in individual portfolios based on each client's financial plan, income needs, risk tolerance and total asset allocation. Interactive checklists are made available to you as self-help tools for your independent use and are not intended to provide investment advice. While Gold Medal Waters believes information derived from third-party sources to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability in regards to your individual circumstances. Investors should carefully consider the investment objectives, risks, charges, and expenses associated with any investment. The information discussed is not intended to render tax or legal advice. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Investing involves risk including the potential loss of principal, and unless otherwise stated, are not guaranteed. Past performance does not guarantee future results. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Consult your financial professional before making any investment decision.