CPA Stephen L Nelson explains what the deduction is and how it can be applied, while coming up with a novel use for the tax deduction, which can be as high as $63,000 for professionals if you’re married, filing jointly, and hit taxable income precisely at “peak deduction” at $315,000.
I’ll let our guest author explain how this deduction can be used to make “tax-free” Roth conversions, potentially decreasing future RMDs and possibly lowering your tax bracket in retirement.
Tax-Free Roth Conversions via the Section 199A 20% QBI Deduction
A little while back, the Physician on Fire asked me about a new tax planning opportunity he and I have decided to call a “front door Section 199A Roth conversion.”
PoF was excited because he saw this new way to do Roth conversions as potentially a neat trick for folks approaching FIRE.
Me? Hey, I’m a tax accountant and so actually enjoy talking about tax law.
This blog post, accordingly, talks about this new-for-2018 Roth conversion opportunity.
Quick Overview of Section 199A Deduction
Sorry, we need to start by digging into the tax accounting…
Section 199A provides business owners with a deduction equal to the smaller of either 20% of their taxable income (net of any capital gains or losses and before the Section 199A deduction) or 20% of qualified business income.
What is “qualified business income?” Qualified business income includes sole proprietorship profits, real estate investment profits as long as someone’s real estate activity rises to the level of a trade or business, then the ordinary income from an S corporation or partnership. (The ordinary income, just so you know, is the amount that appears in box 1 of the S corporation or partnership k-1.)Section 199A Changes Rules for Investors.
One other important wrinkle: Professionals (including doctors and dentists, attorneys and accountants, and then a bunch of other folks as well) only get to use the 20% deduction when Section 199A’s measure of their taxable income falls below $157,500 and the taxpayer uses the single filing status or falls below $315,000 when the taxpayer uses the married filing status.
But this important point: Those taxable income thresholds mean most professionals, including most physicians, can use the Section 199A deduction.
For example, a married high-income professional taxpayer might earn (say) $500,000. But the taxpayer’s family could still qualify if deductions for pensions, self-employed health insurance, health savings accounts, self-employed taxes, alimony, mortgage interest, charity contributions and state taxes drive the family’s taxable income down to or below $315,000.
Similarly, an individual high-income professional taxpayer might earn $250,000 and use the same sorts of deduction to drive her or his taxable income down to or below $157,500.
But this key point—which is often misunderstood: Adjusted gross income doesn’t matter. What matters is that the taxable income falls at or below the thresholds. When that is the case, the taxpayer gets the deduction.
Big Deduction Means Big Savings
One other quick background point: The deductions and the tax savings get big. And fast!
A married taxpayer with a taxable income equal to $315,000 might get a $63,000 deduction, for example.
That deduction might save the taxpayer around $15,000 in federal taxes.
That deduction might save the taxpayer around $7,500 in federal taxes.
Note: A taxpayer can use the Section 199A deduction even if her or his taxable income exceeds $157,500 or $315,000. But for a business owner earning income in a specified service trade or business (which includes basically any professional), the deduction phases out going from 20% to 0% as the taxpayer’s taxable income rises from $157,500 to $207,500 or from $315,000 to $415,000. (For more detail about how this occurs see this blog post: Section 199A phase-out calculations.)
Section 199A Roth Conversion Connection
On its face, Section 199A doesn’t have anything at all to do with a Roth conversion. Nada. Zilch.
But noodle around with the tax accounting a little bit, ponder the benefits of a Roth-style IRA or Roth-401(k) account, and you pretty quickly see something interesting…
Business owners with significant tax-deferred retirement account balances should consider using the Section 199A deduction to avoid income taxes on Roth conversions.
In other words, a business owner (including a partner or shareholder in a group medical practice) with a $20,000 or $40,000 or $60,000 Section 199A deduction might in effect use that deduction to shelter $20,000 or $40,000 or $60,000 of “Roth Conversion” income from federal taxes.
You need to be careful about that math. Remember the usual rule is that you want to pay the tax when your marginal tax rate is lowest. For many folks that won’t be will not be when working and earning a high income. Rather, the lower tax rate occurs when retired.
However, consider these factors if you’re going to end up with a big tax-deferred retirement account balance.
First, federal income tax rates are noticeably lower for middle-class and upper-class taxpayers for at least the next few years even before the Section 199A deduction. If you can qualify for the Section 199A deduction, your marginal rate is 24% or lower, for example. And probably you were paying a higher rate than that in 2017 and therefore may pay a higher rate than that starting in 2026 when the current low tax rates expire.
Second, while on average you might not save that much tax if your marginal rate today is 24% and your marginal rate during retirement is 25% or 28%, large Roth account balances may let you avoid a late-in-retirement problem: Needing to take big draws from tax-deferred retirement accounts due to “required minimum distribution” rules. (Those bigger draws very well may push you or your surviving spouse into a higher tax bracket.)
Third, remember that while today most retirees are not subject to the 3.8% net investment income tax (aka the “Obamacare” tax), many upper-middle-class and upper-class taxpayers will be subject to net investment income tax at some point in their fatFIRE retirement.
The reason for this? Those $200,000 and $250,000 trigger points for paying net investment income tax aren’t subject to inflation indexing. This means that if the Obamacare tax stays the law, eventually inflation will push many taxpayers above these limits and mean these taxpayers pay a higher marginal rate on any investment income. (The net investment income tax doesn’t hit retirement income by the way.)
Final Front Door Section 199A Deduction Conversion Comments
If you want to use your Section 199A deduction to shelter Roth conversion income, you want to start thinking about the tactic now—and also learn about the law.
You will want to be very careful in your accounting if you’re close to the threshold “taxable income” triggers. (Remember, too, that the Roth conversion income will push up your taxable income.)
But with some planning and flexibility, many folks should be able to move a few hundred thousand dollars from tax-deferred IRAs, SEPs and 401(k)s to to Roth accounts without (in one sense) paying additional income taxes.
CPA Stephen L Nelson is the managing member of a Seattle CPA firm. The author of many best-selling books about accounting, including QuickBooks for Dummies, he regularly writes on tax topics like Sec. 199A at his Evergreen Small Business blog and is the author of a popular though somewhat expensive monograph ($150 ) for tax accountants and attorneys, Maximizing Section 199A Deductions.
What do you think? Are tax-free Roth conversions a good way to “spend” your QBI deduction? Will you qualify for the QBI deduction this year?
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