Qualified retirement plans were a good deal before the December 2017 Tax Cuts and Jobs Act.  For many professional firms, they’re now better than ever.

Here’s the new part:  many owners of pass-through businesses like S corporations, LLCs and sole proprietors are eligible for a 20% deduction on Qualified Business Income (QBI), essentially non-W2 business income (profits).

For “specified service businesses”, i.e. most professional firms, the 20% deduction is limited in 2018 for owners with income of more than $315,000 (married) or $157,500 (single) [1].  It’s completely eliminated for owners with income of more than $415,000 (married) or $207,500 (single).

If your income is below the threshold, you’re eligible for the entire 20% deduction.  If your income is too high, retirement plan contributions can bring it down below the threshold.

The combined effect of the retirement plan and QBI deductions can be astonishing.

Let’s take the example of Rachel, a 50 year old married partner in a successful LLC.  Her share of the firm’s profits is $376,000.  If she maximizes her 401(k) deferral and the firm maximizes her profit sharing contribution (total of $61,000 with catchup), her income has dropped to $315,000.  She’s entitled to the $61,000 deduction and, in addition, she can now deduct the entire 20% of QBI.  The table below shows how it works:

 With 401(k)/ PS Contribution

 Without 401(k)/ PS Contribution

 Income before contribution [2]

 $  376,000

 $   376,000

 Retirement plan deduction

      (61,000)

              –  

 Income before QBI deduction

     315,000

      376,000

 QBI deduction
 Full deduction percentage

20%

20%

 Adjusted % (phase-out)

20.00%

7.80%

 Deduction amount

       63,000

        29,328

 Federal income tax (FIT) [3]

       43,299

        66,634

 FIT savings

 $    23,335

By contributing $61,000 to her own retirement account, Rachel has reduced her 2018 taxable income by $94,672 and her federal income taxes by $23,335.  And that doesn’t even include her savings in FICA or state & local income taxes.

What if Rachel’s firm is even more successful, so that her share of the profits is $526,000?  With the right demographics, it’s still possible to contribute enough to bring her income down to the $315,000 threshold.  To do that she’ll need a cash balance plan, which works especially well for professional firms.  Partners around age 50 can contribute up to $150,000 – in addition to the $61,000 401(k)/profit sharing contribution.  Older partners can contribute more than that: up to $280,000 cash balance at age 62 – for a total contribution of $341,000 (!) with 401(k) and profit sharing.

The next table shows this scenario for Rachel:

 With
Cash Balance and 401(k)/PS Contribution

 Without
Cash Balance and 401(k)/PS Contribution

 Income before contribution [2]

 $     526,000

 $      526,000

 Retirement plan deduction

       (211,000)

                 –  

 Income before QBI deduction

        315,000

         526,000

 QBI deduction
 Full deduction percentage

20%

20%

 Adjusted % (phase-out)

20.00%

0.00%

 Deduction amount

          63,000

                 –

 Federal income tax (FIT) [3]

         43,299

         127,079

 FIT savings

 $       83,780

This time, Rachel has reduced her 2018 taxable income by $274,000 and her federal income taxes by $83,780 by contributing $211,000 to her own retirement accounts.  And that still doesn’t include her savings in FICA or state & local income taxes.

Qualified retirement plans have always been a sweet deal for professional service firms.  And they just got a lot sweeter.

At this writing (October 2018), there are just a couple months left to set up a plan for 2018.  You’ll need to run some numbers, make the necessary plan design decisions and have a signed plan document in place by December 31.  Just let us know if you’d like to take a look.

 

[1] It’s also limited to 50% of W2 pay in many cases.  We’ve chosen a partnership-taxed LLC to simplify this example.

[2] Assuming the same non-owner retirement plan contributions in both columns.  In real life, non-owner contributions are an important plan design component – but we’ve simplified them here.

[3] Simplified calculation ignoring AMT and non-standard deductions.