{"id":6738,"date":"2018-05-21T06:04:24","date_gmt":"2018-05-21T13:04:24","guid":{"rendered":"http:\/\/evergreensmallbusiness.com\/?p=6738"},"modified":"2019-01-25T07:26:01","modified_gmt":"2019-01-25T15:26:01","slug":"sec-199a-changes-retirement-planning","status":"publish","type":"post","link":"https:\/\/evergreensmallbusiness.com\/sec-199a-changes-retirement-planning\/","title":{"rendered":"Sec. 199A Changes Retirement Planning"},"content":{"rendered":"

\"Pictures<\/a><\/p>\n

Okay, a weird thing about the pass-thru “Section 199A deduction\u201d created by the new tax law. Section 199A changes retirement planning for some small business owners.<\/p>\n

Some entrepreneurs should consider abandoning, temporarily, traditional retirement accounts like 401(k)s and IRAs.<\/p>\n

Confusingly, other business owners may want to do just the opposite and boost their use of traditional retirement accounts.<\/p>\n

Still another group of business owners probably want to sharpen their pencils and look seriously at a multi-year Roth conversion strategy.<\/p>\n

If you own a business, therefore, you want to learn the gritty details of new law. And consider carefully how it changes taxation of an individual business owner’s income.<\/p>\n

Note:<\/strong> This blog post’s information has been updated for the final Section 199A regulations which appeared on January 18, 2019.<\/p>\n

Section 199A Deduction Substitute for IRA or 401(k)<\/h1>\n

A first technique some small business owners in states without income taxes may want to consider? Using their Section 199A deduction as a substitute for a traditional IRA or 401(k) retirement account.<\/p>\n

But let me explain this technique using a simple example.<\/p>\n

Suppose you run a successful sole proprietorship earning $100,000 a year. Further say you\u2019re married and will use in 2018 the new $24,000 standard deduction.<\/p>\n

Your taxable income in this case equals $76,000 before the Section 199A deduction.<\/p>\n

The Section 199A deduction in this case, however, adds another deduction to your return. That deduction equals 20% of the $76,000 of taxable income, or $15,200, which drops your taxable income another $15,200 down to $60,800.<\/p>\n

And so here’s where Section 199A changes retirement planning…<\/p>\n

In this situation, if you operate your business and live in a state without income tax, you have little reason to use a tax-deferred retirement account. You may as well use the tax-sheltered income and the savings created by the $15,200\u00a0 Section 199A deduction for retirement savings.<\/p>\n

Note:<\/strong> Seven states don’t tax income:\u00a0Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.<\/p>\n

Rather than contribute, say, $5,500 to your IRA and possibly your spouse\u2019s IRA, you may just want to contribute that money to a potentially taxable account.<\/p>\n

How Tax Accounting Works<\/h1>\n

No, wait, I know that sounds counter-intuitive. But consider how the tax accounting works in a situation like this.<\/p>\n

First, you don\u2019t need to contribute to an IRA or 401(k) to get a tax deduction that helps fund your retirement savings.<\/p>\n

For example, you don\u2019t need a $5,500 IRA contribution to put a $5,500 tax deduction on your tax return.\u00a0You actually get an automatic $15,200 tax deduction simply because you own a profitable business.<\/p>\n

Second, the new Section 199A tax deduction itself shelters investment income that you might have paid federal income tax on prior to Section 199A.<\/p>\n

At the income level described here, the Section 199A deduction pushes the household taxable income down well into the new 12% tax bracket which means that roughly $17,000 of your qualified dividend income and long-term capital gain income will be subject to a 0% tax rate.<\/p>\n

Note:<\/strong> To learn where the 12% tax rate bracket ends for other filing statuses, you can look at Oblivious Investor’s web post\u00a0here.<\/a><\/p>\n

That $17,000 of \u201cbreathing room\u201d maybe doesn\u2019t sound like that much space. But you might actually be able to have nearly $1,000,000 in a stock market index fund before you pay taxes on qualified dividends and long-term capital gains.<\/p>\n

Note:<\/strong> Qualified dividends from the Vanguard total stock market index fund run about 2%.<\/p>\n

IRA Deduction May Reduce Sec. 199A Deduction<\/h1>\n

Now, yes, you are absolutely correct that contributing $5,500 to a traditional IRA or 401(k) gets that taxpayer another $5,500 of annual tax deduction. That deduction annually saves her or him perhaps another $660 of taxes in a situation like that described here. But maybe those savings aren’t that compelling.<\/p>\n

Do note someone further reduces their taxable income with an IRA or 401(k) contribution and that that reduction also reduces their Section 199A deduction. (In the example given here, that reduction in the Section 199A deduction “costs” about $130 of lost Section 199A tax savings.)<\/p>\n

Now we’re talking not $660 of lost annual tax savings but maybe $530 of lost savings.<\/p>\n

And then look at the big picture where someone foregoes those annual tax savings by using a taxable account. Over 35 years, she or he accumulates roughly $500,000 in real dollar terms (if they earn five percent annually and contribute $5,500 each year). The taxpayer will have paid $18,000 to $19,000 in income taxes over those 35 years. Which is a lot. But she or he\u00a0then draws down that money without paying income taxes.<\/p>\n

That seems a reasonable choice for some taxpayers living and working in or planning to retire to states with no or very low state income taxes…<\/p>\n

Other Disadvantages of IRA and 401(k) Accounts<\/h1>\n

You know what else to remember? Remember you lose some other subtle benefits by putting money into an IRA or 401(k) account.<\/p>\n

Often we don\u2019t think much about these other lost benefits, but they become more significant in a example like that described here.<\/p>\n

Consider, for example, these drawbacks of an IRA or 401(k) plan as compared to a taxable account that isn\u2019t actually taxable:<\/p>\n