The new tax rules implemented by the Tax Cuts and Jobs Act (TCJA), which went into effect in 2018, added a new deduction for income received from a pass-through entity.

The new tax rules implemented by the Tax Cuts and Jobs Act (TCJA), which went into effect in 2018, added a new deduction for income received from a pass-through entity.1 This deduction can be as large as 20% of the income earned by the business; although, in many cases, some very complicated rules will reduce this deduction. However, for business owners who receive all or most of the 20% maximum, the tax reduction is significant. The decrease in the effective tax rate on business income also affects the investment arithmetic that should be considered when you, as an owner-operator of a business, consider how to save for your own retirement.

Retirement Savings Using Qualified Retirement Plans

Historically, much retirement savings has been accomplished through “qualified” retirement vehicles such as 401(k) plans, IRAs, pensions, etc. These were and continue to be subject to many complicated tax rules. In return for complying with these restrictions, the tax code allowed plan participants who were also business owners to create a rate advantage. The rules let you deduct amounts contributed to a retirement plan in the year when the money was added to the plan, but defers the taxation on these amounts until a future date (i.e., during retirement) when you take withdrawals from the plan. This could create a tax advantage by allowing a deduction during a participant’s working years when their income and tax rate would be higher than in retirement, when both would likely be lower.

How the New Tax Law Impacts Retirement Savings

New Sec 199A of the TCJA changes this arithmetic. It provides a deduction for pass-through income at the time it is earned. So the deduction for a contribution to a qualified retirement plan would be taken against income that is taxed at a lower rate. Then, when withdrawals or distributions are taken from the retirement account, the tax rate applied could actually be higher (since there would be no Section 199A deduction available at that time). One effect of this new tax regime is to increase the attractiveness of contributions to Roth accounts. Although specific income limits will restrict someone’s ability to contribute directly to a Roth IRA, 401(k) plans can freely add a Roth feature if it’s not already permitted, which will let someone contribute to a Roth 401(k) even if she is highly paid. A Roth 401(k) can be rolled into a Roth IRA using essentially the same rules that allow a traditional 401(k) account to be rolled into a traditional IRA.

Develop a Financial Plan to Determine which Course is Right for You

Developing a financial plan can provide business owners with an excellent sense of the direction that would be best to save for their own retirement. It should take into account current sources of income as well as what is expected in the future. It’s also helpful to consider the potential impact of an involuntary change in income.

Our financial planning resources can help you establish an effective retirement savings and income plan, while addressing today’s needs as a business owner. Contact us today to get started.

1. IRC Sec 199A

Janney Montgomery Scott LLC, its affiliates, and its employees are not in the business of providing tax, regulatory, accounting, or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

 

About the author

Michael Repak

Vice President & Senior Estate Planner

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