February 15, 2018
How Does the New Tax Law Affect Retirement Programs?
So, let’s start off with the easy stuff. All the discussion about reducing deferral/contribution limits and maximum account values fell by the wayside. There are no changes on how much a business owner can contribute to his plan or how much can be paid out at retirement.
While the tax bill is still being tweaked, the biggest change for business owners of pass through entities (e.g., S-Corp, partnerships, and sole proprietorships) is the lower tax rates. Most business owners will experience a small reduction in their overall tax rate in the range of 2% to 3% over the prior year – this translates to a 32% to 37% net tax rate.
So, do retirement plans still make sense?
Yes! A retirement program for a business owner with only W-2 income still makes sense – nothing really has changed. It is still one of the best ways to reduce current taxes and save for retirement. All contributions made by the business owner (for both the staff and themselves) offsets taxable income – dollar for dollar.
Where things get a bit more interesting is when the business owner can shift a portion of the W-2 earnings to K-1 distributions or a similar non-W-2 income source. The new tax law permits the business owner to deduct upwards of 20% of non-W-2 earnings to reduce taxable income. This can be a huge win. Below is an example of how a few friends, discussing the new tax law over lunch, would be affected:
Chandler earns $250K (W-2) – under the new law he will pay $60K in taxes based on a 24% tax rate ($250K x 24%). Chandler is depressed.
Monica, also earns $250K but her CPA instructed her to reclassify $50K as K-1 distributions. Monica’s taxable earnings drop to $240K ($250K – the 20% deduction on the $50K K-1 distributions) – she will pay $57.6K in taxes based on a 24% tax rate ($240K x 24%). A tax savings of $2.4K over Chandler, Monica feels very smart.
The question that many business owners then ask is, “if you get this 20% deduction why not move as much over to K-1 distributions as possible?” The answer is two-fold: 1) this could be a red flag for the IRS with most CPAs not recommending this course of action and 2) the IRS has limits as to how much non-W-2 income can be recognized in determining the 20% offset. (see below)
The limit on the 20% offset is based on total income. As a joint filer:
- the 20% deduction of non-W-2 income is limited to the lessor of 50% of W-2 earnings and the non-W-2 income. This prevents a business owner from gaming the system (i.e., moving a large amount of income to non-W-2 status to try to lower taxes).
- if total income is greater than $415K there is no 20% deduction permitted
- if total income is greater than $315K but less than $415K the 20% deduction on non-W-2 income is phased out pro-rata
- One exception – engineers and architects are excluded from this compensation restriction
So back to the question – are retirement programs still viable? The answer is still yes! If the business owner can reclassify a portion of the W-2 salary as non-W-2 income, even lower taxes can be produced. The business owner can fund a retirement program using the non-W-2 income further reducing taxable income. See below:
Rachel earns $250K and is interested in making a retirement contribution for the 2018 plan year. Like Monica she reclassifies $50K as K-1 distributions. From her $200K W-2 she defers $18.5K into her 401(k)/profit sharing plan and contributes $36.5K as a profit sharing contribution. Her total 2018 pre-tax contribution is $55K ($18.5K + $36.5K).
Her $200K W-2 is reduced by the $18.5K 401(k) deferral and the $50K K-1 distribution is reduced by the $36.5K profit sharing contribution leaving only $13.5K in non-W-2 income. Her taxable income is now roughly $192.3K [($200K – $18.5K) + ($13.5K – the 20% deduction on the $13.5K)]. She will pay $46.2K in taxes based on a 24% tax rate ($192.3 x 24%). A tax savings of $11.4K over Monica which makes her very happy.
Lastly, for those business owners making more than $415K, who are ineligible for the 20% deduction, the retirement program remains one of the best ways to claim a legal tax deduction. One last example (and it is a good one):
Joey, earns $500K and under the new tax law will be paying $175K in taxes based on a 35% tax rate ($500K x 35%). Like Rachel he wants to reduce his taxes so he sets up a 401(k)/Profit Sharing/Defined Benefit Plan. The retirement consultant confirms that he can reduce his taxable income by the $18.5K deferral into his 401(k)/profit sharing plan, $16.5K as a profit sharing contribution, and based upon his age (48) a $173K defined benefit contribution. His total 2018 pre-tax contribution is $208K. Therefore, Joey is reflecting:
- $275K W-2 less ($18.5K 401(k) deferral) = $256.5K
- $225K K-1 distributions less ($16.5K + $173K) = $35.5K
His taxable income is now only $284.9K [($256.5K) + ($35.5K – the 20% deduction on the $35.5K)]. He will pay $91.2K in taxes based on a 32% tax rate ($284.9K x 32%).
Not only was Joey able to cut his taxes almost in half, by use of the retirement program he was able to get under the compensation limit to fully reflect the 20% deduction on non-W-2 income and LOWER his tax rate to 32% from 35%. But most importantly he has a big smile on his face since he did not have to pick up the tab for lunch.
Each business owner’s situation and demographic is different and finding the right mix of W-2 and non-W-2 income will require input from the CPA and the retirement consultant. This new tax legislation busts open the doors to greater creativity/opportunity in lowering taxes owed by business owners when using a retirement plan regardless of their income level.
To learn more how a 401(k)/Profit Sharing or Defined Benefit/Cash Balance Plan can lower the tax obligations for a business owner please contact please contact your Retirement Sales Director at The Benefit Practice or call (203) 517-3502.
