The QBI Deduction in Retirement Planning

The QBI Deduction in Retirement Planning

In his Forbes column, Co-Director of the Retirement Income Center at The American College of Financial Services, Steve Parrish writes about the Qualified Business Income or “QBI” deduction and how it can be used as a retirement planning solution.

Retail companies sometimes sell additional product by placing their wares in more than one location. At grocery stores, pita bread may appear both in the bread section and near the cold cuts. Candy shows up in the candy aisle, but also near checkout. This is a concession to the fact that people have different ways of classifying the products they choose to buy.

Similarly, there’s a popular tax provision from the Tax Cuts and Jobs Act (TCJA) that deserves to be classified as more than just a business tax cut. What’s commonly called the Qualified Business Income or “QBI” deduction is typically pegged as a tax saving provision for business owners. And it is. Simply stated, when the TCJA dropped corporate taxes from a maximum 35% tax rate to a flat 21%, owners of pass-through businesses, such as S Corps, LLCs, partnerships and sole proprietors, wanted a tax break as well. Under TCJA, Sec. 199A was crafted to offer as much as a 20% deduction from these business owners’ qualified business income. The law, which is admittedly complex, has nonetheless saved many companies significant amounts of income tax.

That being said, the QBI deduction deserves shelf space on other financial idea racks as well. Beyond its value as a business tax tool, it should also be classified as a retirement planning opportunity – and a very good one at that. In situations where a prospective retiree is not planning to cease all income-generating work once the gold watch has been conferred, the QBI can be both a tremendous source of tax savings and a way to boost retirement income.

Gliding into retirement

Let’s consider how QBI works in retirement planning with an example. A prospective retiree wants to work part-time, partially for the money, but also to ease into leaving the workplace. She has the skill set, time and motivation to consult for the industry from which she’s retiring. While she wants to be done with full-time employment, she still hopes to continue to work a few years before taking up shuffleboard. How should she approach her desire to consult after retirement?

The default is that she secures part-time employment. But this raises two problems. First, she must pay ordinary income taxes on the wages she receives, without receiving the employee benefits typically reserved for full-time employees. Second, she won’t have the independence she craves after working for so many years as an employee. A better approach for her is to become an independent contractor – essentially own a consulting business. This gives her the freedom she wants; she sets her hours and determines when to take vacation. And now, with the passage of the TCJA, there are also financial benefits to being an independent contractor. Instead of paying income tax on every dollar she earns as a part-time employee, because of the QBI rule she will only pay tax on eighty cents of each dollar. Additionally, she will be able to write off her business expenses against her income.

Assume, for example, that the year after she retires, she bills out $55,000 in consulting fees. When she reports this on her tax return, two benefits help lower her taxes on her consulting income. She will be able to deduct her business and entertainment related expenses on her Schedule C. And these expenses are not limited by the 2% adjusted gross income floor required for unreimbursed employee expenses – an issue that could arise if she were a part-time employee. Next, her net $50,000 in consulting fees represents qualified business income under Sec. 199A, and she can deduct up to 20% of this amount on her personal taxes. Since she and her husband have a combined taxable income of less than $315,000 (where the limit starts reducing), she will be entitled to the entire 20% deduction, or $10,000.

This allows for some interesting retirement planning opportunities. First, it provides a comparatively low-taxed source of post-retirement income – income that she can use instead of claiming Social Security. While she receives her consulting income during her mid to late 60s, her deferred Social Security benefit increases at 8% per year. Additionally, if she doesn’t need all this income for living expenses and wants further tax advantages, she could use some of her consulting income to contribute to a Roth IRA. This would allow her to build up after-tax funds that will not be subject to Required Minimum Distributions when she reaches age 70 ½. Say she ceases consulting at age 70. She can start receiving maximum Social Security benefits, but not have to take taxable RMDs on her Roth IRA. This saves taxes on her Social Security payments while offering a source of tax-free income for later in life.

The disadvantages of using the QBI deduction for this retiree are few. She will have to pay self-employment tax on her consulting income. However, the 20% QBI deduction more than offsets the additional 6.2% in FICA she incurs. Also, instead of having taxes withheld from wages, she will likely need to file quarterly tax estimates. One perceived disadvantage of self-employment may in fact be more illusory than real. There is no question that Sec. 199A is incredibly complex, arcane and otherwise daunting. Except, the tricky calculations this provision entails don’t apply to this situation. For a person running a solo consulting business, the additional tax burden of calculating and reporting the QBI deduction is negligible.

This planning tool is not limited to only a few situations. Most so-called encore careers for soon-to-be retirees will involve some kind of service or trade – teaching, recruiting, coaching, consulting, seasonal support, etc. Few individuals retiring from their jobs will be building factories or hiring staff. This means they will likely be classified as a “specified trade or business” for purpose of Sec. 199A, and there are limitations on the taxable income such business owners can have in order to obtain the full 20% deduction. The limitations are, fortunately, liberal. They don’t begin to reduce the deduction until taxable income for a married couple reaches $315,000 ($157,500 for a single individual). For most retirees, this will not be a concern. According to a 2018 Economic Policy Institute study based on Social Security data, 95% of wage earners make less than $300,000 per year. Those individuals who have begun their retirement glide path with this QBI tax technique may not be working full-time, and may not be as focused on maximizing income.

Also, such businesses are comparatively straightforward to create. Some individuals may file as an LLC in order to limit their personal liability, but many will simply run their business as a sole proprietorship. Similarly, exiting their encore career is usually as simple as just stopping. They benefit from the QBI deduction until they cease working.

Sunsetting

There is a caveat to the issue of availability of this tax benefit. The QBI tax provision, like many of the tax changes in the TCJA, sunsets at the end of 2025. Beginning in 2026, the 20% deduction disappears. So, if a prospective retiree is contemplating setting up a part-time business before riding off into the sunset, now’s the time to start.

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