What you need to know about the idiotic “QBI deduction reduction” rule

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In the frenzy to pass the Smash-and-Grab Tax Act of 2017, a faction of Republican senators who, totally coincidentally, are the owners of passthrough businesses, insisted on including a special treat: in addition to tax cuts on the profits of C corporations, and cuts to the personal income tax rates they pay on their passthrough income, they demanded that their taxes be reduced again by what’s known as the “qualified business income deduction.”

Like all deductions, the benefits of the QBI deduction flow overwhelmingly to the highest-income taxpayers, since it lowers the marginal tax rate of the lowest-income business owners from 10% to 8%, and of the highest-income business owners eligible for the full deduction from 24% to 19.2%, a benefit 2.4 times larger.

For folks with simple tax situations, calculating the deduction is complicated, but no more or less so than optimizing any other combination of deductions and credits. However, the new deduction created one issue that causes an enormous amount of confusion: the QBI deduction reduction.

What is the QBI deduction reduction?

The 20% QBI deduction is applied, as the name implies, to a figure called “qualified business income,” which for simple passthrough businesses is simply net profit minus half the self-employment tax. For the 2019 tax year, you multiple that number by 20% and write it down on line 10 of Form 1040, right below the standard deduction, before arriving at your final taxable income. In other words, a dollar earned by a business which is reported on form 1040 doesn’t increase your taxable income by $1, it increases it by just $0.80 (after deducting half the self-employment tax).

This creates a problem, however, since deductible contributions to SEP IRA’s and individual 401(k) accounts are reported as adjustments to income on Part II of Schedule 1, but do not reduce the amount of business income reported on Part I of Schedule 1.

If nothing were done, this would allow the owners of passthrough entities to deduct the same income twice: in the 24% tax bracket, a $19,500 solo 401(k) contribution would reduce the owner’s tax by $4,680, and then the QBI deduction applied to the same income would reduce it by another $936. This would create an additional, unintended tax subsidy for deductible retirement contributions; in some cases it would even allow the QBI deduction to be used to offset earned income!

For that reason, the QBI deduction reduction was introduced: qualified business income is reduced by both half the self-employment tax and by the amount of any deductible contributions made to SEP IRA’s and individual 401(k)’s. The owners of passthrough entities thus have to choose: on a given dollar of income, you can either make a fully deductible retirement plan contribution (to be taxed on withdrawal), or a 20% tax cut, but not both.

This is sometimes confusingly referred to as making pre-tax retirement contributions only “partially” deductible, but this is incorrect, as the above should make clear: pre-tax retirement contributions are fully deductible at the rate they would otherwise be taxed at. The reason you “only” receive a 19.2% deduction for pre-tax retirement contributions when your income puts you in the 24% tax bracket is that 19.2% is the applicable tax rate, after the application of the 20% QBI. This is a full deduction, at the applicable tax rate.

What’s the problem

This is, obviously, a pain in the ass, but any reputable tax software is capable of making the necessary calculations. It does, however, raise two extremely important issues to be aware of.

The first issue is the decision between making deductible, pre-tax contributions to retirement plans or Roth, after-tax contributions. That’s because Roth contributions do not reduce QBI or the QBI deduction in the way pre-tax contributions do. One way to approach the decision between pre-tax and after-tax contributions is to select a “pivot” point: if your income puts you in the 24% tax bracket, you might decide to make deductible contributions down to the 22% bracket, and Roth contributions after that.

But if a 22% tax rate is your pivot point, and the QBI deduction means you’re actually paying 19.2%, then 100% of your contributions should go to Roth accounts! Your marginal tax rate is already lower than the point at which you prefer to save taxes today and pay them later.

The second issue is the allocation decision between individual retirement accounts and small business retirement accounts, since contributions to traditional IRA’s are fully deductible and do not reduce QBI. Before the introduction of the QBI deduction, a business owner could be essentially indifferent between traditional and Roth IRA and solo 401(k) contributions. All traditional contributions were fully deductible, and all Roth contributions were taxable, at the applicable rates.

With the QBI deduction reduction in place, these allocation decisions became extremely important, since a $6,000 traditional IRA contribution reduces taxable income by the full amount, while a $6,000 solo 401(k) contribution reduces it by just $4,800. If your IRA contributions have been on autopilot, it’s time to turn it off: deductible contributions should always go first into IRA’s, and only then should you decide how to split solo 401(k) contributions between pre-tax and Roth accounts.

Conclusion

As tax time gears up, wrangling with these issues has also been an opportunity for reflection, since I have both earned income and self-employment income that put me squarely into the 12% income tax bracket. The advice I would offer a stranger in my position would be to maximize Roth contributions to both their IRA and solo 401(k), paying 12% and 9.6% marginal rates now, and saving them on the presumably much larger balances they’d withdraw 30, 40, or 50 years from now.

The problem, of course, is that I’m in the 12% income tax bracket because I’m poor, and this is indeed the entire problem with a retirement system that requires people to make carefully calculated bets each and every year. A $6,000 traditional IRA contribution is worth $720 to me, a $6,000 traditional 401(k) contribution worth $576 more. Do I want an embedded tax asset that I’ll redeem decades in the future, or do I want $1,296? Go ahead and guess.

It’s become fashionable to describe Americans as being “financially illiterate,” but I hope someday we get around to acknowledging that the text we’re constantly being exhorted to read should never have been written in the first place.

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