A New Tax Warning for Business Owners

I’ve been self-employed for the last decade and I’ve been doing my own taxes for as long as I’ve had income so I’ve learned an awful lot about both things over the years.

Now, after recently getting a letter from the IRS regarding my 2018 return, I have some new insights to share with you about where the two areas intersect – specifically why the advantages of a special retirement plans for business owners have just gotten a bit less attractive under the new tax laws that went into effect for 2018.

Here’s the Background…

As a self-employed person, I’ve been using a special type of retirement plan for years now and it’s already helped me keep more than $500,000 in income away from Uncle Sam’s greedy hands (at least for the foreseeable future).

It’s called a Solo 401(k) or an Individual 401(k) and I’ve universally recommended them to anyone else with self-employment income… whether from a primary business or a side hustle.

To use one, you just have to own a business and you can’t have any employees other than your spouse.

You can be a sole proprietor… a partnership… a corporation… it doesn’t matter.

Solo 401(k) plans have many of the same features as their regular brethren.

One of the biggest? You can deduct your contributions come tax time.

The difference is that you can put away a lot more money every year.

Just to illustrate the point:

Like regular 401(k) plans, your employee “elective” contributions couldn’t exceed a maximum of $18,500 for the 2018 tax year ($24,500 if 50 or older).

But in addition to that amount, Solo 401(k) plans also allow your employer — i.e. YOU — to make additional profit-sharing contributions every year – up to a maximum of $36,500 last year.

All told, that means the total limit was $55,000 for 2018 (or $60,000 for folks 50+).

To take full advantage of the sky-high maxes, you have to earn a significant amount of money in any given year. All the details on the rules and calculations via the IRS here.

However, the point is that Solo 401(k) plans offer the most generous total contribution caps available just about anywhere.

One New Wrinkle with Trump’s Tax Changes…

The amount you deduct for contributing to a solo 401(k) – or another pre-tax retirement account like a SEP or SIMPLE IRA – reduces the amount of money that benefits from the new 20% deduction for qualified business income (QBI).

That came as a surprise to me.

After all, you don’t deduct your retirement contributions on Schedule C… which is the record of your net self-employment income. They’re a separate line item on the 1040 itself (more specifically, line 28 on Schedule 1 of the new 1040).

As a corollary, any deductions you have related to self-employment health insurance also reduce the amount of pass-through income that qualifies for the deduction (line 29 of Schedule 1). 

Same goes for the deductible tax on your self-employment income (line 27 of Schedule 1).

You can get the full set of regulationshere.

Here’s the Upshot…

The new 20% QBI deduction somewhat reduces the value of contributing to a tax-deferred plan like a Solo 401(k).

Does that mean you should forgo contributing? No. Everyone’s situation and goals are different.

Just as an example: I live in the high-tax state of California. My Solo 401(k) contributions reduce my taxable income at the state level even as California ignores the new QBI deduction.

I’m simply pointing out that anyone with self-employment income has a new variable to consider when they pencil out their yearly tax planning.

To a richer life,

Nilus Mattive

— Nilus Mattive
Editor, The Rich Life Roadmap

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