The 2017 Tax Cuts and Jobs Act (TCJA) presents major changes for most taxpayers, especially for high-income earners. Evaluating the effects of the new law, made effective for the 2018 tax year, depends on several factors. Limitations and phase-outs to the 20 percent pass-through deduction are important to keep in mind for financial and tax planning.
Sole proprietorships, S-corporations, partnerships, and LLCs are recognized as “pass-through” entities because their profits are taxed at individual rates, passed through to the owners or partners, rather than at corporate rates. TCJA allows owners of pass-through businesses to deduct 20 percent of their business income.
However, there’s a catch (as there often is when it comes to taxes): the deductibility of pass-through income is limited by income levels as well as by business classifications. Both limitations affect medical professionals: high-earners see the deductibility phase out over certain income thresholds. Additionally, professional service businesses (such as law firms, financial advisors, and medical providers) have limited opportunities for deductibility of pass-through income.
About the Tax Cut & Job Act (TCJA)
In general, the TCJA makes income level changes for pass-through businesses in these ways: for taxable incomes below $321,400 for married/filing jointly couples (or $160,700 for single filers), the 20 percent deduction is fairly simple. Between $321,400 and $421,400 (or $160,700 and $210,700), the deduction phases out and completely goes away above $421,400 and $210,700, for married and single filers, respectively.
The new tax rules may or may not make a significant change to your tax and retirement planning. Following are a few examples to help you understand the changes in tax landscape.
Depending on your tax bracket, your approach to retirement plan savings may differ. It goes without saying that making contributions to a retirement plan is a necessary move, regardless of your income tax bracket. No one can guarantee where tax brackets will be in the future, but no matter your politics or your viewpoint, it’s probable that you’ll be in a higher tax bracket at retirement. Taking steps, then, to reduce the amount of taxes you’ll pay now and defer unneeded income to retirement is a smart move.
How can pension or retirement plan contributions help a professional take advantage of the pass-through income deduction? In a January 2018 information release, Kravitz/Cash Balance Design explains:
“a married shareholder doctor’s total taxable income is $456,400, and by contributing $135,000 or more to a cash balance plan, his or her effective federal tax rate could drop to 19.5 percent.”
The $135,000 contribution would reduce the income to $321,400 (the threshold for taking the pass-through deduction). The 20 percent deduction on $321,400 would reduce the taxable income from $321,400 to $258,400 ($321,400 less $63,000). From this example, one can see the importance of significant qualified retirement plan contributions.
What is a Cash Balance Plan?
A cash balance plan allows for larger qualified retirement plan contributions, based on age and length of time to retirement. Characterized as a qualified plan, each participant in a cash balance plan makes a contribution which is then credited a guaranteed interest rate each year, unlike investment-driven retirement plans.
Thanks to the new tax rules, many wealthy professionals and their advisors are reviving the idea of the traditional pension plan as a way to lower their tax liability. A cash balance plan is a good option for successful business owners who currently fund their profit-sharing 401(k) plans to the limits defined by the IRS and want to shelter more income from taxes, writes Ben Steverman in Accounting Today magazine.
Prior to the TCJA of 2017, most people could count on a dollar-for-dollar tax deduction for contributions to qualified retirement plans: put a dollar in a retirement plan, take a one-dollar deduction on your taxes. Now, with the new tax law, a couple of work-arounds might allow for a “super-deduction” of more than one dollar for each dollar contributed.
Cash Balance / Pass Through Deduction Examples
Consider the following examples from John Hancock: A doctor owning a medical practice shows a business income of $250,000 on his K-1. His tax return shows an adjusted taxable income of $200,000. The doctor can take the lesser of 20 percent of the qualified business income (QBI) or 20 percent of the taxable income (in this example, $40,000). This limitation relates specifically to income below the $321,400 married/filing jointly threshold.
The John Hancock example further details the limitations on incomes over the threshold amounts, especially for professionals in Specified Service Trades or Businesses (SSTB), including medical professionals. For 2019 limits ($421,400 for married/filing jointly), the example shows a professional who makes $250,000 per year. His spouse has additional income that pushes the couple’s income over $450,000, disqualifying the couple from the 20 percent pass-through deduction.
Further, the example from John Hancock places SSTB earners (including doctors) into three categories when it comes to retirement plan contribution planning and minimizing tax liabilities. The first are professionals with taxable incomes over the threshold amount who can utilize qualified retirement plan contributions to reduce taxable income and in effect, receive a super deduction.
Physicians Making Around $420,000
Consider a physician whose taxable income is right at the $421,400 threshold for 2019. Because he is characterized as a SSTB, he does not qualify for the 20 percent pass through deduction. However, with $100,000 of contributions to a blend of a 401(k) plan and a cash balance plan, he can reduce his taxable income to $321,400 and qualify for the 20 percent deduction, resulting in a deduction of $64,280. Here’s where the “super deduction” comes in: the $100,000 contribution resulted in $164,280 of tax deductions --- not a bad deal for a high-income earner.
Taxable Income of $300,000
The second category in the example from John Hancock shows a professional whose taxable income is $300,000, qualifying him for the 20 percent deduction. Is he better off to take the $60,000 deduction or to deduct $50,000 for a contribution to a SEP IRA plan as a sole business owner? In this example, the doctor is better off taking the $60,000 deduction and then contributing money to a Roth 401(k) option to reduce tax liability in retirement.
Wealth Physicians (Earning Greater Greater than $500K) Annually in Taxable Income
The third category belongs to physicians who earn too much money to even get close to qualifying for part or all of the 20 percent pass-through deduction. In these cases, the medical professional should stay the course, contributing as much as possible to traditional qualified retirement plans as well as cash balance plans, continuing to take advantage of whatever deductibility available for such contributions.
As is shown by the preceding examples, your retirement contribution considerations, coupled with your income level, make for a scrambled web of tax planning options. In short, as a medical professional, you are classified by the Internal Revenue Service as a specialized professional, so you’ll deal with income thresholds and limitations as they pertain to the 20 percent pass-through deduction. Then, it really comes down to where you fall on the income scale: if you’re below the threshold, you might consider the strategy of reorienting your retirement plan contributions not for their tax deductibility now, but for the taxes they may save you in retirement when you save after-tax dollars. If you’re in the middle --- the sweet spot, or, for some, the confusing spot --- then you’ll most definitely want to consider your options in terms of maximizing deductibility and getting your income below the threshold to take advantage of at least some of the pass-through deduction, as well as beefing up your retirement contributions through a cash balance plan. If you’re above the threshold for the deduction, stay the course.
Tax law changes are never without complications or confusion. Work with a trusted, qualified financial professional as well as with a CPA to determine your best course of action.