Small businesses have a lot of competing needs for their business resources. One of these resources is the use of their cash. Cash availability, or free cash flow, varies quite a bit from company to company, depending on their specific situation.
No matter how much free cash flow you have, small businesses should consider using some or all of their free cash flow to contribute to a retirement plan. The Tax Cuts and Jobs Act (TCJA) may provide a valuable tax deduction to small business owners through contributions made to retirement plans. In addition, retirement plans offer many other advantages to the business owner.
How does a retirement plan help the small business owner(s)?
You do have one-time costs when establishing a retirement plan. You also have annual administration and compliance fees. In spite of those costs, there are many attractive advantages to sponsoring a retirement plan for your employees and yourself.
Retirement plans provide businesses with an immediate tax deduction for amounts contributed to the plan. This deduction became a bit more valuable for pass-through entities, such as sole proprietorships, LLC’s, partnerships and S corporations, under the TCJA.
Additionally, you do not recognize taxable income until funds are eventually distributed from the plan. All earnings on your contributions accumulate tax-deferred within the retirement plan. With some financial planning, you may even defer taxation on these retirement funds further by rolling them over to an IRA and properly designating beneficiaries. Doing so can stretch out tax deferral beyond your lifetime.
A lesser-known benefit that retirement plans provide is protection from creditors in the event of a lawsuit or bankruptcy. This is an invaluable risk-management benefit to small business owners to protect their retirement plan assets.
Let’s not forget how important a retirement plan becomes for promoting recruitment and retaining employees. Many times, an individual makes their employment decision on whether or not there is a vehicle for savings, such as a retirement plan. Offering a retirement plan helps small business owners attract and keep the most skilled talent.
Now, what about the TCJA taxes and that deduction?
First, retirement plan contributions provide an immediate deduction that could place the business owner(s) in a lower tax bracket. For example, it is most beneficial if your retirement plan contribution deduction reduces taxable income sufficiently to lower your tax bracket to 24% from a 32% tax bracket. That represents a 25% reduction from the 32% tax bracket.
Next, the TCJA introduced a new business tax deduction that allows owners of pass-through entities to reduce their taxable income by up to 20% of the entity’s net profits or qualified business income (QBI). The deduction comes from Section 199A of the IRS Code. The new 20% 199A deduction rules are complex. They have income limitations and trade or business limitations, which may reduce or disallow this deduction. Because of limitations, retirement plan contributions might help the small business owner secure a 199A deduction and ultimately save taxes.
If your QBI is over a certain income amount, you no longer receive a 20% 199A deduction. Instead, you are subject to a formula that may limit this deduction. If you are over the QBI threshold, your 199A deduction might be limited to the lesser of 20% of your QBI or 50% of W-2 wages, for example.
A sole proprietor with earned income above the QBI threshold may not receive a 199A deduction when using the formula because they have no wages as a sole proprietor. To benefit from the 199A deduction, the taxpayer may decide to incorporate as an S corporation. Through incorporation, they may now receive a wage for their personal services for the business. This allows for a 199A deduction due to wages, which are no longer zero.
In addition, the same taxpayer may contribute to a cash balance plan as part of their S corporation compensation. With reasonable wages and a retirement plan contribution deduction, you may be able to lower QBI sufficiently to receive a 199A deduction and save taxes.
Specified Service Business Sweet Spot
Under the TCJA, certain specified trades or businesses (accountants, healthcare, legal field) will not be able to take advantage of the 20% 199A deduction, unless the owners have taxable income below certain income thresholds. For these businesses, the 199A deduction phases out once taxable income exceeds an income amount ($157,500 for single and $315,000 for married filing jointly). The 199A deduction becomes zero and provides no tax relief over the phase-out limit.
If an S corporation owner’s taxable income is above the 199A phase-out income limit, and therefore receives no 199A deduction, the taxpayer may be able to reduce their QBI to the threshold by contributing to a retirement plan. By finding the “sweet spot” between reasonable compensation and retirement plan contributions, for example, the S corporation owner may be able to reduce taxable income sufficiently to allow for a 199A deduction.
Begin planning today
There are many benefits of sponsoring a retirement plan, such as a cash balance or 401(k) plan, for small business owners. The TCJA provided an additional way that retirement plan contributions may help owners of pass-through entities lower their tax burden. These new rules are complex, so talk to your tax advisor. With the year-end approaching soon, now is the time to look at how a retirement plan may benefit your business.