Has New Tax Law Twisted Business Owners Best Interests When It Comes to Retirement Savings Plans?
Article for Fiduciary News, written by Christopher Carosa, CTFA with contributions from Michael Olivia.
Small businesses make up the vast bulk of the businesses in America. They may be full-time businesses, or they may be side hustles that bring in a few extra bucks during the moonlight hours. Many of these businesses are family-owned, especially the part-time businesses. Revenues from these businesses can fund retirement plans in ways employees can’t normally use their corporate retirement plans. This has become most apparent as the impact of the new tax law begins to trickle down from the accountants to the business owners.
The new tax law had an immediate effect on many people. With the reduction of tax rates, people saw an increase in their take home pay as tax withholding has been reduced. What may surprise some, however, is with lower tax withholding comes smaller refunds (because people aren’t overpaying their taxes the way they used to). In an added twist, a change in the standard deduction has made long-time tax reduction strategies irrelevant.
Taxable deductions have diminished in value. A new strategy is required. “For individuals, it becomes increasingly more important to reduce taxable income,” says Patrick Di Fazio, Director of Wealth Management Consulting, and Matt Zokai, Senior Advisor of Retirement Services, both at 1st Global in the Dallas/Fort Worth Area. “The new tax law has increased the standard deduction to $12,200 per individual, $24,400 for married filing jointly. The higher standard deduction eliminates the need for many tax payers to itemize ‘below the line’ deductions.”
“As a result of the Tax Cuts and Jobs Act, individuals no longer have the ability to deduct many items that were previously allowed,” says F. Michael Zovistoski, Managing Director at UHY Advisors NY, Inc. in Albany, New York. “These items include: state income and real and personal property taxes in excess of $10,000, Interest costs relating to Home Equity Lines of Credit, Alimony paid on divorce decrees entered into after December 31, 2018, and all miscellaneous itemized deductions, such as employee business expenses, investment expenses, and tax preparation fees, among others. Many taxpayers in the past may have taken advantage of certain tax strategies to bunch cost in a selected year to maximize the deductions and in turn, minimize tax. With the inability to take these deductions, taxpayers will be looking for other methods to legally minimize taxation.”
One reliable avenue for tax reduction remains. “The new tax law has left fewer ways to reduce taxation,” says Mark Wilson, President of MILE Wealth Management in Irvine, California. “Maximizing retirement plan contributions is one of the few options left.” This is good news for all retirement plan fiduciaries.
With the new law virtually eliminating personal deductions, retirement saving rises in standing. “Retirement plan contributions allow clients to reduce their taxable income because they allow clients to save for retirement on a tax-deferred basis,” says Marguerita Cheng, Chief Executive Officer at Blue Ocean Global Wealth in Gaithersburg, Maryland.
“With fewer deductions available under the new tax rules, retirement plans can make a huge difference,” says Mike Sedlak, Financial Adviser and Managing Member of Golden Trail Advisers in Burr Ridge, Illinois. “Also, you might be able to get under the $315,000 income limit by contributing to a retirement plan.”
Of course, retirement plan contributions have the added advantage of solving two different problems. “Many taxpayers are now searching for ways to reduce current tax or at least defer taxes to the future,” says Zovistoski. “Additionally, many Americans are coming to the realization that they may not have saved enough for their eventual retirement. Contributions to a retirement plan fit both of these needs. The contribution limits for 2019 increased to encourage taxpayers to save for retirement. (IRA, 401(k), 403(b), 408(p)(2) and 457 plan limits all increased $500 from 2018 to 2019).”
While the concept of using retirement contributions to lower current tax liability remains the same, the actual implementation has changed. In some cases, the change may be quite dramatic. “Depending on a particular client’s situation, the new tax law provides planning opportunities,” says Michael Olivia, Senior Partner with WestPac Wealth Partners located in San Diego, California. “Regardless of tax law or circumstance, the approach is the same – entity selection, maximizing deductions, tax deferral/sheltering and income shifting all help to create strategies to push back against tax bills. One of the more significant pieces of the legislation was corporate tax rate cut from 35% to 21%. Of course, most businesses would not qualify for the tax break, as many small businesses are LLC’s taxed as C or S corporations. To level the playing field, the legislation introduced IRC § 199A. This deduction became automatic for some, but for others, the business would only qualify for the 20% deduction if their income was below the predetermined threshold. This amplifies the importance of income shifting, tax deferral and maximizing deductions.”
More than merely “leveling the playing field,” this may give small businesses a leg up. “This new tax law actually favors small businesses that are ‘pass through,’ which is everything that’s NOT a C-Corporation,” says Ben H. Feldmeyer, Private Wealth Advisor at Feldmeyer Financial Group in Dayton, Ohio. “So, sole proprietor, S-Corp, LLC, partnership, etc… all get a 20% reduction in business income – unless they fall into a specifically named category, then the benefit is limited. – It is, however, too complicated to explain in the space allowed here.”
Some of that complication comes in the income limits imposed by the new law. “For business owners,” say Di Fazio and Zokai, “the full 20% deduction of qualified business income (QBI) is only available to business owners with total taxable income less than the $315,000 threshold for joint filers. When taxable income exceeds the threshold, the 20% deduction may be reduced based on a wage of capital limitation.”
Sedlak offers an example that shows how this can make a big difference.” He says, “Let’s say you would have $400,000 of taxable income. In certain service industries (e.g. broker, CPA, engineer), you would not qualify for the qualified business income (QBI) deduction because you are over $315,000. But if you put $122,000 into a retirement plan for you and your spouse, you would fall below the $315,000 figure and you would be able to deduct 20% of your business income before paying federal taxes. So, in this example, the family is not only saving taxes by deferring money into a retirement plan, they are also saving 20% of business income. That comes out to $55,600 [($400,000 – $122,000) x 20%].”
Because of these income caps and hurdles, the best solution may not be as apparent as it once was. “The new tax law has both reasons to have a tax deferred arrangement and not to have,” says Chris Cooper, Private Fiduciary at Chris Cooper & Company in Toledo, Ohio. “It impacts the QBI under section 199A to get the 20% reduction in taxable income. So, one has to be careful before putting in pensions, profit sharing, 401k, SEP’s and all.”
This makes it all the more important to get tax advice from a professional before proceeding too far. “For S Corp and other pass through entities,” says Andrew Bellak, CEO of Stakeholders Capital in Amherst, Massachusetts, “those business owners should consult with their CPAs about the tax law changes to compare how great a contribution may make sense. That is, the maximum may NOT make sense even if a person has the capacity to do so.”
You may have to think really far outside the box on this one. Ilene Davis of Financial Independence Services Cocoa, Florida, does just this when she says, “actually, with lower tax rates, current savings aren’t as beneficial for tax reduction, and the ultimate goal of retirement plan should be long term financial security. The tax deduction is icing on the cake.”
Joshua Sutin, head of Employee Benefits/ERISA practice at Chamberlain Hrdlicka in San Antonio, Texas, agrees with Davis. He says, “Since income tax rates are at the lowest point in our lifetimes, it would be a good idea to pay tax now and let the retirement grow and be distributed tax free in a Roth IRA. If rates go up, you can go back to pre-tax deferrals. Either way, qualified plans are critical to protect assets, save for future expenses, and are still very tax efficient for income tax purposes notwithstanding low rates. If you qualify for the new IRC § 199A deduction on Qualified Business Income, lowering your taxable income could qualify some professions to not be phased out of the deduction.”
Along these same lines, Matthew P. McKee, Financial Advisor at Samalin Investment Counsel in Chappaqua, New York, says, “Reducing one’s tax liability is always important but due to the elimination or reduction in other deductions, other strategies, such as retirement plan contributions, have become more important. However, this option is complicated by one of the most impactful changes coming from the Tax Cut and Jobs Act – IRC § 199A, which is better known as the QBI Deduction. IRC § 199A created a 20% deduction for pass-through profits for qualifying businesses and impacts the pretax retirement plans for many small business owners. The 199A deduction is based on net income (after retirement plan contributions), so the retirement plan contributions can actually reduce the tax benefit of the 199A deduction. Therefore, you may not get the full tax benefit of the retirement plan tax contribution but still have to pay taxes on the distributions in retirement. More important than which plan to choose is figuring out how this change to the tax code effects your contributions. Unfortunately, it is difficult to suggest one solution that fits all as each circumstance can vary significantly, but there are other options such as Roth accounts or Roth conversions.”
Unlike non-business owners, those who own businesses aren’t limited to the traditional Roth IRA option (with it’s lower contribution cap). They have the option to create more sophisticated retirement plans that vastly increase the amount they can save. “Small business owners typically get tax breaks under the new tax law,” says Kenn B. Tacchino, a professor of taxation and financial planning at Widener University in Chester, Pennsylvania. “These tax breaks can lower the current tax liability. With rates as low as they currently are, it may be a great time for Roth contributions to a 401k plan. This will allow the small business owner to enjoy tax diversification when they are retired. In other words, by making Roth contributions today, they will be able to better control their tax situation tomorrow.”
Michael Menninger, President at Menninger & Associates, Inc. in Trooper, Pennsylvania, believe saving for retirement via tax deductible contributions “is the fallacy that most baby boomers have been led to believe for many years. Interestingly,” he says, “the new tax laws actually make it more beneficial to NOT contribute to the deductible portion of retirement plans, as I have found that folks who build up a sizeable amount in their deductible 401k/IRA plans will actually find themselves in a higher marginal tax bracket in retirement than they are today.” Menninger teaches taxes to CPAs. He says, “they were shocked to hear that comment, but after explaining, they understood and agreed. That said, if there is a Roth 401K option, then it allows the participant to contribute significantly larger amounts to their Roth in a given year and/or the retirement plan allows for Roth contributions where they may otherwise be eligible to do so based on their income. In the event that the business owner is trying to reduce his income below a threshold that still allows him to deduct 20% of his profits (this applies to certain service companies under the new tax laws), then having this option available to contribute MORE to the retirement plan can be beneficial.” Menninger is so impressed with this strategy that he is employing it for his own business.
Regardless of how one saves for retirement – whether with pre-tax money through traditional vehicles or after-tax money with Roth vehicles – the value to society cannot be underestimated. “From a long-term perspective,” says Zovistoski, “making contributions to a retirement plan is not only a good way to save for retirement, through dollar cost averaging, but the taxpayer also reduces current taxation and defer taxes for many years until distributions. The more individuals save for retirement, the less strain there will be on future government programs, such as Medicaid and EBT, during retirement and the stronger the economy will be in the future, as those who saved will have money to spend on housing, food, entertainment, and alike.”
The new tax law may have added a twist to retirement saving, but it retains the primacy of encouraging such behavior. In the end, this may have a advantageous impact on us all.
Christopher Carosa is a keynote speaker, journalist, and the author of 401(k) Fiduciary Solutions, Hey! What’s My Number? How to Improve the Odds You Will Retire in Comfort, From Cradle to Retirement: The Child IRA, and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). OSJ: 4275 Executive Square #800 La Jolla, CA 92037 619.684.6400. Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is an indirect, wholly-owned subsidiary of Guardian. WestPac Wealth Partners, LLC is not an affiliate or subsidiary of PAS or Guardian. Insurance products offered through WestPac Wealth Partners and Insurance Services, LLC, a DBA of WestPac Wealth Partners, LLC. CA Insurance License #0E571168 | 2019-75371 Exp. 02/21