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.
A single taxpayer with a taxable income equal to $157,500 might get a $31,500 deduction.
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.)
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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?
50 thoughts on “Tax-Free Roth Conversions via the Section 199A 20% QBI Deduction”
Quick question – Our total income (married filing jointly, wife does not work much) will be somewhere around 350K. I make 135K W2 income as a professor. The rest is via 1099s from my sole proprietorship LLC (consultant and professional speaker). However, I will likely contribute around 18-20K to my SEP IRA, which will bring my taxable income down – correct? And then there are all my business deductions (travel, supplies, etc) which typically come in at around 15-20K each year. I think this, along with my charitable contributions, will get me below the 315K mark. But am I understanding this correctly – that both my SEP contribution and my business expenses will help me get to the 315K mark? If I get the Section 199A deduction, I will consider a Roth conversion. Thanks for a fantastically thought provoking article!
Jess – I’m no CPA, but if you are near the $315k taxable income mark and if your trade or business is a “specified service business” (it probably is) then you need to be careful with the interplay of any Roth conversion you do, and the phaseout territory. The Roth conversion increases your taxable income, and could result in a decrease in your 199A deduction.
What about real estate that I run as a business? The income is reportable on Schedule E, so then where will the Section 199A deduction get calculated?
Larry, if your real estate activities rise to the level of a trade or business–and it sounds like they do–you’ll potentially include a Section 199A deduction on your 1040 tax return too. And reporting that Section 199A deduction will work just like any other Section 199A deduction.
We don’t BTW have all the forms, line numbers, etc. Those will probably appear soon though…
BTW, real estate won’t be subject to any phaseout based on the “specified service trade or business” thing… but it will possibly be subject to phase-out based on W-2 wages and depreciable property.
POF- I have found you though Doximity and your story has been inspiring. I have been working towards FI (without any knowledge of the FIRE community) but do not know yet about the RE part yet. Relatively new to this so my apologies if my question is basic. Thanks
As a 48 y/o Family Doc – 14 years in employed practice and earn my pay through W2 and 1099 incomes.
W2 as an employed physician – projecting this year to be above the 315,000 cut off for Married filing jointly but my 1099 income is less than 100,000. The 1099 income is from Nursing Home Medical Director work in which I do not provide any “profession services to the resident (of the nursing home) as part of the duties of the Medical Director”. I find the concept of a possibly large Roth contribution intriguing however I do not have an formal/legal documents “forming” a business so..
My question is how do you determine Qualified Business Income? Is it based on the way I am paid W2 vs, 1099 vs. other? Is it based on the presence of Schedule C income? or?
So your 1099 income gets reported on a Schedule C along with a handful of other expenses. But whatever bottomline number your Schedule C shows, you potentially get to calculate a 20% Section 199A deduction using that value.
Example: You earn $100K through 1099 work and have $20K of expenses… your profit equals $80K and you’ll roughly get a $16K (20% of $80k) deduction.
I think your 1099 stuff is specified service trade or business BTW… so big issue will be what your taxable income is:
Example: You make (say) $400K as a W-2 employee and $80K as a 1099 contractor (so $480K total income) and your tax return includes $60K of deductions. In this case, you won’t get any Section 199A deduction. Your total income will be $420K and you’ll be above the phase out range.
But another example: What if your W-2 equals $320K… and your Schedule C 1099 contractor stuff equals $80K… so $400K total income. And then say you have a $40K pension deduction, $10K state taxes, $30K mortgage and $10K charity. Now your taxable income equals $310K so you aren’t phased out… and you do get the Section 199A deduction.
Stephen – thanks for the great explanation
Say then that hypothetical Greg elects to do some Roth conversion. Perhaps even a dollar for dollar conversion to match the $16k QBI deduction, as the article here is talking about. Isn’t that conversion going to push him into phaseout territory?
Aaron, so that’s right. You need to (as noted above) do the math carefully. You would not want to convert so much that you push yourself into the 32% tax bracket which, then due to the phase out, is actually a higher than 32% tax rate.
So to sum it up, you are suggesting that people should use the income taxes they saved under the 20% deduction to pay for Roth conversions, and that doing so now may be a good idea because of lower tax rates under the existing tax law.
The tax law itself doesn’t allow for tax free conversions.
Delightful article and KUDO to PoF as well for recognizing this.
I notice you say you’re not big on Roth conversion. I’ve done extensive analysis and found over time (decades) it’s a winner especially given the present tax environment. It does take time to get over the SOR cost of conversion but the tax payoff, especially when one spouse dies is spectacular. Maybe I missed something in my analysis. I heard today Trump might extend the age when RMD becomes mandatory, which could further bring down the cost of conversion by allowing a longer conversion period. I’m presently converting $340K per year on zero income (I’m living on cash in the bank) with a tax bite of $64K, married filing jointly one person over 65. I also have a big wad of tax loss harvested and a big taxable account which makes my taxable a rich man’s Roth, so I wouldn’t tap the Roth for decades if I ever do. My concern is returning to 2017 taxes or worse. IRA’s are a huge pile of potential tax-ability. All they have to do is force RMD up 1% and your retired tax bill goes up accordingly with one simple change. Danger Danger Will Robinson
I like what you’re doing, Gasem. With the new 24% federal income tax bracket going all the way up to $315,000, that’s a huge low-tax space in which to do Roth conversions.
If I find myself in a low-income position between now and 2025, I plan on filling up the 24% bracket with Roth conversions. Fortunately, only a small percentage of my portfolio is tax-deferred, so it wouldn’t take long to get to a position where all of my investments are post-tax (Roth and taxable brokerage account).
Gasem, not sure I understand all your points. But to echo and underscore one thing you point to… those RMDs can become brutal at point someone is single.
If rates return to 2017 levels–they’re supposed to do that in 2026–only a single person with taxable income below $38K would be paying a low marginal rate of 15% at that point.
I guess my question is what is your perspective on Roth conversion tnx
My old opinion on Roth conversions: I thought they were generally overrated because most people (at least in past before new tax law) pay a higher marginal tax rate while working than they will in retirement.
Note: I acknowledge RMD issue… but then other stuff like assisted care expenses late in life and possibility someone dies with large IRA balances which go to heirs at lower rates, etc., also are issues.
That said, the folks for whom Roth-style accounts regularly did make economical sense in past were people currently in very low brackets (since they don’t pay a very high tax rate today) and people with high incomes but high net worths (since they may always pay the top rate).
The new tax law, however, changes this up I think… rates for the next few years are historically pretty low. Someone might today, for example, be paying a 24% marginal rate on $300K of taxable income… and then in future be paying a 25% tax rate on $40K of taxable income. Or a 28% rate on $90K of taxable income.
These are also my feelings.
Even if the tax rate doesn’t change, with the present tax schedule the growth curve first dips slightly below the RMD payout curve due to the upfront cost of conversion but eventually crosses the RMD curve and accelerates in growth. The accelerated compounding growth and tax efficiency can make a significant net increase in the money available just when something like long term care is rearing it’s head. In some respect the RMD tax savings compounded over some decades is like self insuring for long term care. All it cost you are taxes you would have had to pay anyway.
The conventional wisdom is put off paying taxes as long as possible which makes sense unless you come up with a scheme where compounding and efficiency makes the “taxes” pay you back in the long run, like the 199 scheme. The devil is in the details for sure but the payback can be handsome Bravo
Stephen, (cc: PoF)
I don’t see a “Reply” on Stephen’s post above.
I still don’t see any tie to 199A; the dollars in the $60k 199A deduction in your example are no different than the dollars in the family’s already existing $100k deduction. Or some other $60k deduction that they might come upon. But we don’t have to go back and forth on this.
Educate me here. Physician family has a taxable income of $315k before considering their $50k 199A deduction. So they “spend” their deduction on $50k in Roth conversions. Is this a complete wash, keeping the taxable income at $315k so there’s no phaseout of the 199A deduction for a specified service business?
I had read previously that the 199A deduction would come later on the return such that the deduction itself would not reduce Taxable Income (as on 1040 line 43). If this were true, the dollar-for-dollar Roth conversion in my example would then result in a partial phaseout of the 199A deduction for this family which of course would be counterproductive.
But I see on the new draft 1040 that the QBI deduction is above the line for taxable income. So the Roth conversion would be “cancelled out”.
Which scenario is correct?
It’s a wash as long as someone is below threshold.
I.e., with $300K of taxable income and $300K of qualified business income, the Section 199A deduction equals $60K.
If you did a Roth conversion for $60K, this family’s taxable income would equal
$300K starting taxable income – $60K Section 199A deduction +$60K Roth conversion…. so $300K ending taxable income.
This is the point…
I think what you read earlier probably is part (not all but a part) of where you’re getting sort of stuck.
HOWEVER, that said, I agree with you and PoF that this Section 199A deduction is just another deduction.
So where is the interplay between the 199A deduction itself, and the phaseout?
If someone had taxable income of $365 before an expected 199A deduction of $50k, taxable income becomes $315k, so no phaseout. But at $365k I thought 50% of the QBI deduction was phased out (for a specified service business).
Or do we not yet know how this is going to play out?
We know exactly how the phase-out works. There’s a link in the blog post above that points to a more detailed discussion of how the phase-out math works.
But if you’re in specified service trade or business and your taxable income equals $365K, you unfortunately get hit with two phase-outs… first, as you point out you lose half your Section 199A deduction because of your SSTB status… second, you may lose additional amounts due to inadequate W-2 wages and depreciable property.
The actionable insight here: If you will lose out due to a higher taxable income, can you do anything economically rational between now and the end of the year to drive down your taxable income.
E.g., is this the year you finally set up a defined benefit benefit… contribute some whopping amount to that… and then not only get the DB plan deduction but another $60K of deduction since your taxable income calls below the threshold.
“Tax-Free Roth Conversions via the Section 199A 20% QBI Deduction”
PoF I love the work you do. But is this an intentionally misleading headline? No one is really suggesting the proposed Roth conversion is “tax-free” are they?
“Tax-neutral” might be a better descriptive term. Compared to the 2017 tax code, you can now do this at no cost. You do now have the alternative of pocketing what the new Section 199A 20% QBI deduction gives you, of course.
Sorry, but you can’t do this at “no cost.” You are converting at your marginal rate, same as last year. And calling it “tax-neutral” is just mental accounting that has no special attachment to the 199A deduction, or any other deduction.
I mean, last year I itemized deductions, which allowed me a deduction for paying mortgage interest and also state income tax and making charitable donations. I could have made a dollar-for-dollar Roth conversion last year to cancel out those deductions, same as I could for a 199A deduction this year. But I didn’t. Because I’d rather not pay more tax now.
As we like to say, money is fungible. That concept applies to dollars deducted on your tax return, too.
Precisely. I used the “Money is fungible” line in the comments above. Tax deductions are just money, and they’re fungible, too.
I think that’s the point the author is making. There’s this great new deduction that gives us “free money” as compared to before 2018 and likely after 2025. You can use it as you wish, and one potentially good option for readers with large tax-deferred balances is to make Roth conversions in the 24% tax bracket.
Similarly, a married retiree with very little in the way of taxable income can make tax-free Roth conversions by staying below a taxable income of $19,050. With a $24,000 standard deduction, they may be able to convert $40,000 a year or more if they have kids at home. There are other uses for that space, including capital gains harvesting, a tax-free side hustle, etc… The main difference here is that you aren’t able to pocket the deduction at a higher marginal tax bracket.
I think we see this the same way. I used quotations around “tax-free” in the introduction.
Here’s another take on the guest post title thing… maybe I should have titled the blog post something more along the lines of:
I can go with that idea.
And I think the answer to that question is a definite “maybe” given the temporarily low marginal rates.
For the record, I am not a big fan of Roth accounts. But if I personally get a Section 199A deduction over next few years when we have these low marginal rates, I’m going to try and sneak money out of my tax-deferred accounts and into a Roth-style account
Stephen – I still don’t get the link here to the 199A deduction. In your case, why does it matter whether or not you get a 199A deduction, with regards to a decision on whether to do a Roth conversion or not? Wouldn’t you make that decision based on your marginal tax rate, what you’re willing to pay in tax now, and where you thing your marginal rate in retirement might be?
Further, if I understand correctly (a big IF, I’m not a CPA), the 199A deduction is “below the line”, correct? In other words, a 199A deduction isn’t going to move you into a lower bracket, right? So again, I don’t see the special link to 199A.
I think a most accurate title for the thread may have been something along the lines of: “Hey high income folks, your tax rate probably went down. So you should consider doing Roth conversions.” But that’s not nearly as catchy.
Okay, this may be a case of me saying “toe-may-to” and you saying “toe-mah-to”…
But here’s the way my mind works given an example case.
Say a family has one worker who earns $100K in a W-2 job, $100K in deductions, and than another worker who earns $300K as a partner.
In this case, the taxable income and the qualified business income equals $300K.
Further, the person gets a Section 199A deduction equal to $60K.
That drops taxable income from $300K to $240K. The marginal rate on all this income is 24%. So this saves $14,400 in federal income taxes.
You can do anything you want with that $60K deduction or those $14.4K of tax savings.
But here’s one idea: You could use the $60K deduction to cover $60K of Roth conversion income.
Restated another way: You could use up the $14.4K of tax savings from the Section 199A deduction to cover the $14.4K of taxes on the Roth conversion.
Why would you do this? Well as you note (and as I’ve spent decades trying to convince people) because the marginal rate is quite possibly lower today than it will be in future. In this example, person will probably pay a 25% or 28% tax rate if they don’t convert to a Roth when they take the money out of a tax-deferred requirement account as long as they retire after 2025 when the rates go back up.
I don’t quite understand how these are related. How does a Roth conversion increase your QBI deduction?
The two can cancel each other out, making it a tax-neutral move. Last year, you would have paid taxes at your marginal tax rate on the Roth conversion. This year, it won’t cost a thing (other than giving up the new tax deduction). Does that clear things up?
Seems like just semantics. If your taxable income is $250k and you get a new $50k QBI deduction (new taxable income of $200k), your tax is $36,579. If you do a $50k Roth conversion (your taxable income goes back to $250k), your tax is now $48,579. This is a $12,000 increase, which is 24%. This is your marginal tax rate. So you are still paying 24% to convert. In the first scenario (no Roth conversion), you clearly pay less tax than the second scenario (Roth conversion), so there is no free conversion. I’d rather have the $12,000 tax savings in the first scenario than lose the $12,000 to convert $50,000 of 401k money to Roth.
Right. The main point is that it’s a new tax deduction in 2018 for sole proprietors, partners, real estate investors, etc…
The deduction can be used in many ways; one is to counterbalance Roth conversions, a tactic that might make good sense for someone with 7-figure tax-deferred IRA or 401(k) accounts who will not have many years in which to convert prior to facing RMDs.
You can also take the deduction as cash at your marginal tax rate. Personally, I think the 24% tax bracket is not a bad place to make Roth conversions or contributions, although I know I’ll be moving to a state with a much lower state income tax next year, so I do not plan on making Roth conversions this year. I also expect to be in that phase-out range — another reason it’s not the best option for me.
A taxpayer might use the Section 199A savings in lots of different ways.
Many of those ways might be really good ways to use the savings: after-tax savings, paying down a mortgage, creating a little more space in a household budget, maybe catching up on kids college savings… and then (this blog post’s idea) paying for the taxes on a multi-year series of large Roth conversions.
I’m arguing here that if you have a large retirement account balance, you consider using the combination of temporarily low rates and a large Section 199A deduction to move money from tax-deferred accounts to Roth-style accounts.
+1. As I’m fresh out of residency and have no taxable savings, I’d rather take the $15K now and save up for a house. At top of 24% married bracket now.
Hope to FIRE by mid-late 40s in ~10y as a stay at home dude. Hard to see how we’d be above the 25% bracket at that time, even if wife is still making ~50K and I’m doing Roth conversion ladders to the tune of 100–200K/y (up to 24% or 25% bracket limit).
What if anything am I missing?
The tax reform that took effect this year expires in 2025. I have a strong suspicion income tax brackets will tighten up and rates will increase then. But, if you’re planning to FIRE in your 40s, you’ll probably be in a lower tax bracket even with the assumed changes.
This tactic makes more sense for those working a longer career and accumulating 7-figure tax-deferred balances with less time between retirement and age 70.5 when RMDs kick in.
Tax minimization and optimization strategies are the most complex part of persona finance, in my opinion. I need to understand the laws better. It’s a shame that taxes aren’t as simple as other parts of finance such as earning, saving, and investing.
That said, I think this unfortunately doesn’t apply for me because I’m married, filing separately and still make too much money. Maybe it’s not such a bad problem to have.
For what it’s worth: We’ve seen the Section 199A deduction cause clients to change their filing status (thereby moving the phase-out threshold from $157,500 to $315,000)…
Also, to move to a defined benefit pension plan (so people aren’t saving $50K or $60K but some much larger amount).
And finally to change the depreciation methods used for family real estate investments so large front-loaded real estate losses drive down taxable income.
I re-read this post multiple times but I’m still confused. I don’t understand how conversion of “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” would not be a taxable event.
Sorry if I’m just slow. But, I still don’t get the connection between Roth conversions and Section 199A. But, thanks for the info about Section 199A!
The gist is that you can make Roth conversions up to the value of your 20% QBI deduction and the two will cancel each other out. Since that can be up to $63,000 a year, that can add up to hundreds of thousands of dollars in “free” Roth conversions based on the new wrinkle in the tax code.
Ok, I think I get it. So it really isn’t a free conversion. In the end, you are really converting it at your marginal tax rate. If you convert $20K. You can trick yourself into thinking that the deducted portion is where you get the tax discount, but that just means that the earned $20K no longer gets the discount. That’s the same thing as saying the conversion doesn’t get the discount. After all, 20K + 100K = 120K the same way that 100K + 20K = 120K.
It still seems that the two (Roth Conversion & 199A Deduction) have nothing to do with each other. In my mind, they are still two separate ideas:
1. Check out the great 199A Deduction that small business owners can take!
2. Since your tax rates will be lower this year, and you can deduct more than ever, you should consider converting some of your pre-tax savings into Roth savings!
Still, thanks for the clarification!
You’ve got it. Last year, the Roth conversion would have cost you a lot of money. This year, it won’t because the increased income from the conversion can be counterbalanced by an equal-sized QBI deduction.
Money is fungible. Roth conversions are just one way in which to take advantage of this new gift in the TCJA. You could also choose to pay less tax or offset some other new income.
And the bigger lesson, as you have identified, is that it’s best to be thinking about this new 199A deduction and how if might apply to you.
Agree with PoF.
Another way to frame this reality: One might simply fritter away the tax savings that stem from the lower marginal tax rates we get for the next few years… and then also the tax savings that come from not having to pay taxes on that last 20% of your income due to the Section 199A deduction.
What I’m saying is that some folks, given the low marginal rate and given this “free” deduction, may want to not spend the tax savings on consumption but rather spend the tax savings moving money to a Roth-style account.
The point, then, is recognize the big savings and thoughtfully use the savings.
Interesting. But I’m not following the prediction “But this important point: Those taxable income thresholds mean most professionals, including most physicians, can use the Section 199A deduction.” (emphasis added) It’s a nice sound bit, but this is far from what we are experiencing in our practice. Maybe our clientele is just different, but I’ll have to be convinced otherwise.
Are your physicians earning “too much money” to qualify? It may be that ol’ geographic arbitrage working in their favor in middle America.
Single filers and dual physician or dual high-income couples will have a hard avoiding a partial or complete phase-out, but the majority of married physicians without a high-income spouse will have a taxable income in the range to qualify for the 20% QBI deduction. Of course, this does not apply to employed physicians.
Joanna, I’m basing my statement in post on the average physician income numbers reported in a variety of places. E.g., this source (see below) names the ten locations with highest average physician earnings:
The “ten highest location averages” range runs $350K to $400K. Any of those folks are are married with a spouse who doesn’t work outside the home and who max their 401(k) will get the deduction if they earn their income in as a S corp shareholder or group practice partnership with the partnership agreement written correctly.
BTW, I have no problem believing your CPA firm’s average “physician” client income is higher than average physician. But that doesn’t mean the average physician loses out on Section 199A. Only that your clients do.
I disagree as well that this hits most physicians since they have to be business owners or independent contractors and most aren’t. And many who are make >$500k. I’m in that perfect spot that is IC and has a taxable income under the limit.
I have considered roth conversions but since I control my income I’ve just decided to work up to the taxable income but not over to avoid effective marginal tax rates of around 50%.
Absolutely, one needs qualifying business income to get Section 199A deduction. Good, important point.
But one clarification to make since many misunderstand this point: The formula doesn’t look at AGI, it looks at taxable income. (Gosh, I was talking to a tax CPA and attorney yesterday–and they didn’t get this critical point!)
Accordingly, someone with $500K of total income might easily see their taxable income drop below the threshold once they consider these deductions:
real estate investment losses if taxpayer has sidestepped passive loss limitations or has depreciation deductions because one owns the property out of which their practice operates.
adjustments for AGI, including self-employed health insurance, health savings account, self-employment taxes, pension plan deductions
itemized deductions: including $10K of state taxes, mortgage interest on up to $750K of mortgage debt and charitable giving.
The deduction won’t be available to everyone. It will be available to many… probably most self-employed professionals.
Good points as well. I’ve calculated my taxable income – all my deductions (big ones being i401k/charity).
I might just know this guy: https://www.physicianonfire.com/tax-reform-physicians/ 😉
Most important to true IC people who can control their income is learning about the effective marginal tax rates when this deduction is included. Above $315k TAXABLE income your federal rate is 47%!
It just seems that the tax code always makes it more challenging for doctors. Example is forcing us to do the extra steps for a backdoor roth that would still achieve the same results as a front door roth if they only just removed the income restrictions.
I believe the alimony deduction will be gone starting 2019 (so if you are planning on a divorce, need to have it finalized before Dec 31)
What is the income threshold for single and married professionals where this method is completely phased out (ie. No more tax advantage)
Xray, Section 199A deduction completely gone for income from specified service trade or business (so a medical practice) at $207,500 of taxable income for a single taxpayer and at $415,000 taxable income for a married taxpayer.