Solo 401(k) Contributions and Qualified Business Income Deduction (Pass-Through Deduction)

A reader writes in, asking:

“What is the relationship between the new ‘pass-thru’ income deduction for ‘qualified business income’ and the contribution limits for self-employed retirement plans such as a Solo 401-K?”

Firstly, the new deduction does not have any effect on how much you can contribute to a solo 401(k) — or to a SEP or SIMPLE.

Contributions to such accounts do, however, affect the amount of your qualified business income (QBI) deduction. That is, the deduction you get from pre-tax contributions to such accounts reduces your qualified business income, which reduce your deduction for such income.

Why Do Pre-tax Contributions Reduce Qualified Business Income?

Given that deductions for a self-employed person’s own contributions to a SEP IRA, SIMPLE IRA, or solo 401(k) do not appear on Schedule C (i.e., they do not reduce self-employment income) it surprises many people that such contributions are considered to reduce qualified business income. Nonetheless, they do.

According to the instructions to Form 1040, qualified business income is reduced by “other deductions attributable to the trade or business including, but not limited to, deductible tax on self-employment income, self-employed health insurance, and contributions to qualified retirement plans.”

The Regulations on the topic say essentially the same thing: “In general, deductions attributable to a trade or business are taken into account for purposes of computing QBI to the extent that the requirements of section
199A and §1.199A-3 are otherwise satisfied. Thus, for purposes of section 199A, deductions such as the deductible portion of the tax on self-employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis.”

Those two references only mention contributions to qualified plans (i.e., 401(k) plans, rather than SEP/SIMPLE IRA accounts) explicitly, but it’s clear that the same line of reasoning would apply to SEP IRA or SIMPLE IRA contributions. (Also, for what it’s worth, TurboTax clearly takes that position in its tax calculations.)

Financial Planning Implications

Essentially, your marginal tax rate for qualified business income is lower than it would be without the deduction (because each additional dollar of income causes you to get $0.20 of deduction, subject to phaseouts). In other words, pre-tax SEP/SIMPLE/solo 401(k) contributions aren’t as valuable as they would be without accounting for the QBI deduction.

As a result, Roth contributions would now make sense in some cases where tax-deferred contributions would have made sense before.

Also, if your household is doing some tax-deferred contributions and some Roth contributions, it will be advantageous to make sure that, to the extent possible, your tax-deferred contributions are to accounts that will not reduce your qualified business income. For example if you are self-employed and your spouse has a “regular” job as an employee, it would be preferable for your spouse to make tax-deferred 401(k) contributions while you make Roth solo 401(k) contributions rather than vice versa or doing 50/50 each.

Example: You’re in the 22% tax bracket. A $10,000 pre-tax contribution to your spouse’s 401(k) saves you $2,200 (ignoring state/local income taxes for simplicity’s sake). Conversely, a $10,000 pre-tax contribution to your solo 401(k) only saves you $1,760. That is, at first glance it saves you $2,200, but it also reduces your QBI by $10,000 and therefore reduces the size of your QBI deduction by $2,000 (i.e., 20% of $10,000), which causes an additional $440 of income tax (i.e., 22% of $2,000).

If your business is a specified service business and your taxable income is in the phaseout range, the key message is the same: your marginal tax rate for your qualified business income will be something other than simply your tax bracket. So it will be important to actually do the math before making any related decisions.