[Editor's Note: The following guest post was submitted by Timothy Schmidt, DMD. Throughout Tim's career, he's worked various employment situations — as a W2 employee, a 1099 contractor, and is currently an owner/partner in a dental practice. We have no financial relationship. The 199A deduction has affected many of our financial lives in a big way this year and in this post, Dr. Schmidt describes the changes in his life.]
I’ve been thinking a lot about the 199a (qualified business income) deduction, and how it impacts some of my own tax and 401k decisions this year.
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The 199A Deduction
The 199a deduction is an exciting change in the tax law and potentially very relevant to health care providers. There is an ongoing trend for health care providers to move away from traditional W2 employment in favor of business income. For many, this business income is a supplement to their W2 income and may come from moonlighting (1099 contract worker). Others have eliminated their W2 altogether and are either contracted for all services or are practice owners themselves. I myself am a dentist and practice owner, and my LLC is taxed as an S-corporation.
Now, in case you don’t already know, the 199a deduction applies to anyone that receives business income AND has a final taxable income of no more than $207,500 (single) or $415,000 (married filing jointly)… although the deduction begins to phase out at $157,000 (single) and $315,000 (married). It can also apply to others above this income level but only if their business income comes for a non-service business (providing patient care IS a service business).
Now, how does this deduction affect 401k plans and tax rates? Well, also important to remember, is that the amount of the 199a deduction is 20% of whichever is LESSER of the two: total business income or final taxable income. With that in mind, let’s consider a few scenarios.
How Does the 199a Deduction Affect 401k Plans and Tax Rates?
Scenario #1:
Taxable income is BELOW threshold ($315k married)… and taxable income is LESS THAN total business income.
This group includes contract workers (1099 “employee”) and business owners that are taxed as sole proprietor… and some that are taxed as S-corporation.
EXAMPLE:
An associate dentist is hired as a contract worker (LLC taxed as sole proprietor) and has no W2 income. Her entire income $275,000 is business income and her final taxable income is $225,000. The tax savings is calculated by 225,000 (taxable income) x 20% x tax rate (24%)= $10,800 in tax savings.
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Those are some nice tax savings… but here’s another nugget. In this scenario, not only does the 199a reduce your tax bill, but it also essentially lowers your MARGINAL tax rate by 20%. Meaning, if you were to increase taxable income (like by making ROTH contributions instead of traditional 401k contributions) that increase would be taxed at a 20% discount. So for our dentist in the example above, instead of being taxed at 24%, added income will essentially be taxed at an appealing 19.2%.
So what does this mean for tax/401k planning?
Well, if I were in this position, I would make ROTH 401-k contributions instead of tax-deferred (assuming the option is available). A 19.2% marginal tax rate seems hard to beat, even in retirement. Also, remember that you may receive a 199a tax deduction now but won’t have that deduction in retirement… unless of course, you continue to have business income in retirement. So if somehow tax brackets did not change, and you found yourself in the same marginal tax rate in retirement as you are in now, you would still have a 20% discount in favor of choosing ROTH.
Scenario #2:
Taxable income is BELOW threshold ($315k married)… and taxable income is GREATER THAN total business income
This group includes those who moonlight or have a business on the side in addition to their W2 income. It will also include many pass-through entities taxed as S-corporation.
EXAMPLE:
A Radiologist is employed by the hospital where he makes $250k (W2 income) and is also contracted by another hospital where he makes another $90k (1099). His gross income is $340k but his taxable income is $280k. Tax savings come to $90,000 (business income) x 20% x 24% (tax rate)= $4,320 tax savings
Compared to scenario #1, one significant change is that while the 199a deduction may still effectively reduce your tax rate by 20% (from 24% to 19.2%) on a portion of your income, it will NOT effectively change your MARGINAL tax rate. Which means, if you elect to make ROTH 401k contributions, you will be taxed at 24% on those contributions.
Timothy Schmidt, DMD
This is the scenario that I personally will fall into this year… I have decided to make ROTH 401k contributions this year.
Scenario #3
Taxable income is in the phaseout threshold (between $315k-4 15k married)
EXAMPLE: Dentist owns his private practice and earns $440,000 and has elected to be taxed as an S-corporation. He has decided to be paid $200,000 as W2 income and $240,000 as business income and has a taxable income of $360,000. His tax savings are calculated by $240,000 (business income) x 20% x 45% (phaseout) x 32% (tax rate)= $6,912 tax savings
I find it interesting that the tax law makes a significant change once your taxable income reaches $315,000. All of a sudden, not only do you begin to phase out of the 199a deduction, but you also enter a significantly higher tax bracket (from 24% to 32%). You will want to run your own numbers, but obviously, the 199a deduction has a less glamorous effect whether the taxable income is higher (effectively changing tax rate for a portion of income) or business income is higher (effectively changing the tax rate for a portion of income and marginal tax rate).
Scenario #4
Taxable income is greater than the 199a threshold limit ($415,000)
Sorry, the only way to take advantage of the 199a deduction is either to reduce taxable income or somehow reclassify portions of income to come from non-service business. There is surely more to say on this topic, but not for this article.
Virtually all tax decisions depend on your marginal tax rate. For example, I remember when we first set up a 401k plan in our dental office. My partner and I chose a safe-harbor 401k plan to maximize our contributions. However, at the end of the year when we analyzed our “profit sharing” contribution options, we learned that in order to contribute heavily to our own plans, we would also have to contribute to our employee's plans. In fact, as I neared my max contribution, the required “cost” (amount needed in employee contributions) reached 28%… which also happened to be my tax bracket that year. Needless to say, I would not continue to increase profit-sharing contributions to my own 401k when the cost is greater than my marginal tax rate (time to contribute to taxable?).
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When considering the impact of the 199a (qualified business income) deduction, it can be helpful to consider it an effective reduction in tax rate. And while it’s not quite that simple (the deduction can drop you into a new bracket) this perspective can be helpful for tax planning purposes, including 401k decisions.
Remember, when your taxable income is less than your qualified business income, the 199a (qualified business income) deduction effectively lowers marginal tax rate by 20%… so any additional income you add on will likewise benefit with that lower tax rate. Conversely, when qualified business income is less than taxable income, the tax rate is still effectively lowered, but marginal tax rate is not… and added income will not receive the 20% deduction.
How has the 199a deduction affected your retirement/tax planning? Share your approach and comment below!
Great post — thanks for posting Tim.
Question — I am in a similar scenario in terms of my dental office — with 401K/match/profit sharing I get about 74% of the total contribution, staff 26%. Would you have kept the 401K/profit sharing if you were able to bump up your percentage a little more, maybe by adding a spouse to payroll?
Hi Craig… Nice to hear from another dental brother.
So I added my wife to payroll a couple years ago (the same year I declined to max out my “profit-sharing” portion of 401k).
And by the way, the cost for to max out has gotten better (I believe due to demographic/age changes with some of our employees). I just looked at 2018 and did the math… employees were 18.7% of profit sharing.
Hey Tim thanks for your response!
So if you (meaning you and your wife) are getting 81.3% of the total contribution, I think that’s pretty good! Not sure if you have ever read Collier or McGill Advisory but they usually recommend the doctor + spouse combo get 75% or above for the 401K/match/profit sharing plan to be worth doing.
Just food for thought…you obviously have a good grasp of what you are doing! All the best & good luck
Never heard that number, thanks for sharing. It really comes down to how much the employees appreciate the match. If they view it as part of their salary as they should, then you should be able to get away with paying them a little less so it really doesn’t cost you anything to give them a match.
Unfortunately, employees, especially the lesser paid ones, do not always appreciate it the same way. They’d rather get cash in hand. We have lost some employees to other places because of a dollar/hr difference. They didn’t count the $2-3/hr they were getting as part of 401k/PS + CBP.
Interesting…
My thought when deciding on how much to contribute in profit sharing has been to compare cost… cost (in the form of required employee contributions) of contributing additional amount to my 401k VS. cost (in the form of required taxes) of contributing that same amount to a taxable account.
Thoughts?
The problem with that approach is it ignores the ongoing value of tax-protected growth and asset protection for decades going forward.
Unless I’m not following it (which is entirely possible) the conclusion of scenario #2 isn’t quite right. This matches how everyone thought things worked until early this year. At that point it became clear that not only would tax deferred 401(k) contributions reduce taxable income (meaning you might want to make Roth contributions to increase taxable income as in scenario #1), but they also reduce Qualified Business Income (QBI). What this means is that while the radiologist in the example has a potential $90k QBI deduction, if he makes tax deferred contributions to a 401(k) based on that income, then his QBI will be reduced by the amount of those deductions thereby reducing his QBI deduction.
So if he makes no 401(k) contribution, or a Roth contribution based on his qualified income, then his deduction would be $90k x 20% = $18k, resulting in an $18 x 24% = $4320 tax savings. If he makes a $10k tax deferred contribution based on his self employment income that will result in a $10k x 24% = $2400 tax savings, but his QBI deduction will become $80k x 20% = $16k for a tax savings of $16k x 24% = $3840, a reduction of $480. This means that overall his tax savings from making a $10k tax deferred 401(k) contribution based on his self employment income is $2400 – $480 = $1920 for a marginal tax rate savings of 19.2%.
I’ll take a closer look at it when I get a chance. You are right that employer 401k contributions reduce business income and taxable income. Depending on income levels this can both increase or decrease the size of your 199a deduction.
You may be right…
This year I’m looking into making after-tax “employer” contributions then converting to Roth (Mega Backdoor Roth?).
Has anyone had success with the mega backdoor roth?
I have.
https://www.whitecoatinvestor.com/new-mega-backdoor-roth-ira/
I do not have and individual 401k plan. Rather, it’s a plan our small office offers to all employees.
I’m worried about our plan not passing discrimination testing. I’ve been warned by Paychex 401k customer support that the mega backdoor Roth is not an option. A different 401k advisor thought we would be fine to add the “after tax contribution” and “Roth conversion” option to our current plan but he had never done it before.
Thoughts?
Once you have employees, your practice retirement plan is no longer a do it yourself project.
I’d find someone who has done it before for multiple practices and discuss it with them.
It seems that all these scenarios are assuming a doctor who is married with a non-working spouse, correct?
It might be helpful to clarify those assumptions and mention how different scenarios would affect everything differently. Also how might dual-income couples consider filing their taxes differently to take the most advantage of this deduction (e.g. file separately if one of the two have a large W2 income)?
Lots of moving parts in this one obviously and it’s hard to address them all in one post while keeping that post short enough that people actually read it.
Yea,
That’s probably a rookie move (this is my first time writing a financial article).
I guess it shows my bias (I am married filing jointly with a non-working spouse)
Tim, not a rookie move at all, actually pretty common in a lot of these types of articles directed toward physicians. I get that if you’re trying to compare scenarios you need to make certain aspects constant to make your point (and I appreciated your changing up the demographics in your examples).
It’s also helpful to keep pointing out the specific household-type you’re using for the example (an occas parenthetical remark would suffice as you did a couple times) so those of us less well-versed make sure we’re not making the wrong assumption about our own scenario. Bonus for throwing out some other considerations (e.g. the dual-income couple where one has W2 and one not), even if you don’t drill down those examples in your piece.
Thanks for the piece, the new tax laws really threw some of us for a loop!
I do not have and individual 401k plan. Rather, it’s a plan our small office offers to all employees.
I’m worried about our plan not passing discrimination testing. I’ve been warned by Paychex 401k customer support that it’s bit an option. A different 401k advisor thought we would be fine to add the “after tax contribution” and “Roth conversion” option tonour plan but he had never done it before.
Thoughts?
I’m intrigued by the possibility of “reclassifying” income to non-specified service business income.
The bulk of my income is 1099 contractor income and puts me above the 415K threshold. I set up a defined benefit plan last year that allows me to shovel a huge amount of income into the tax deferred space, and lowered by taxable income such that I was (barely) able to qualify for the 199a deduction in 2018.
Next year, I may not make the cut and would lose the 199a deduction.
UNLESS… I reclassify! How could this be done? Is some of my income for things other than professional patient care? What about business management for example, or consulting ? The hospital would likely be flexible on how the total package is paid…
Tread carefully, I think it’s easy to get in trouble there, but the definitions are not particularly cut and dried.
I’d be interested to hear how it goes.
Has anyone had success reclassifying income to non-service income?
However, I believe the ideas you provided (business management, consulting would NOT qualify)
Great post.
I recently opened a i401k with ground work to allow MBDR contributions. One thing I am reading about 199a is that I may not want to do MBDR because it will potentially eliminate any chance to get 199a deduction. 199a deduction is very new and it seems that the IRS hasn’t been very clear in their opinion(at least in my interpretation) . I am gathering I may not qualify as I am 100% in a field of service. My w2 is approximately $230k and a 1099 (in service field) and my business profit after 20%profit share is around $25k so total $255000(plus $65000 Roth conversion this year) . If I were to file married and seperate I would think I still wouldnt benefit from 199a as I dont have any pass through income. To follow up if we file married jointly our taxable income rises to $1.3m(her income all w2 in a field of service) once again I’m just learning about the 199a but I feel it won’t effect me and thus doing MBDR contributions will be fine.
You’re right that by not taking a retirement plan deduction you might not qualify at all for the 199A deduction because your income is then too high.
I am very interested to hear how the Mega Back Door Roth works out for anyone who has been successful at it. I am investigating the option myself. Trying to adjust our current 401k plan by adding the option to make after-tax “employee” contributions then convert those contributions to Roth.
However, it does seem like the MBDR option is not worth giving up 199a deduction (ie, I will consider MBDR option only if it keeps my taxable income below $315)
I think some creativity would be appropriate here, though certainly one must be careful. Morally, I have no problem being aggressive, not least because the exclusion of engineers and architects from the specified service business income limitation has no fair basis. I await further guidance from tax professionals (are they specified service businesses? :0)
If your only income is from your work as a physician here’s what I’ve come up with from reading and doing my own analysis –
Make pre-tax contributions to get you to the bottom of the QBI phase-out range which is $315,000 for married and $157,500 for single of taxable income. Starting at the top of the phase-out range ($415,000/$207,500) and making pre-tax contributions actually “supercharges” the tax benefit of your pre-tax contributions.
Once you’ve reached the bottom of the phase-out range then you should switch to post-tax/Roth contributions.
That’s a neat pearl, thank you!
The math on this analysis is pretty involved so I like to plug the different scenarios into my tax planning software. I went ahead and did that for each of the three to figure out the marginal tax rate on the pre-tax retirement contributions.
You can find my results linked here – https://bit.ly/2XERuJf
Let me know if I missed anything and I’ll update the document.
Now THAT sounds like a great idea!
Thanks all for the comments.
This was my first go at a financial article. It took longer to put together than I would’ve expected… but it was fun to work through the numbers. Sorry it was so dense/math-heavy
Thanks you for an article excellently written. I found the examples made it much easier to understand. For instance, the message that one doesn’t qualify for the deduction if taxable income is >$415k, even if QBI is under this cutoff.
Have a question for you- why did you opt to make Roth 401k contributions if you fall under Scenario #2: since your Roth contributions will be taxed at your original tax bracket, not a discounted tax rate?
Are you talking to me? Because I didn’t make Roth 401(k) contributions.
I was referring to Tim, the author. He mentioned at the end of Scenario #2 he would like to go the Roth route.
I was initially thinking to make Roth contributions mostly because current tax rates are historically low and because my accounts are currently mostly tax-deferred (some diversity seems ideal).
I actually still haven’t made my 2019 contributions and am undecided on whether to make tax-deferred or Roth. I’d really like to make 19k tax-deferred then fill Roth via the mega backdoor Roth option.
Historically low compared to what history? Only 58 years in a country over 200 years old.
I get your point now. I thought you somehow meant your decision on Roth had a benefit wrt the 199A deduction in this scenario. I understood why a Roth contribution made sense for scenario #1, wasn’t sure for #2. Thanks for clarifying
Two doc household – W2 income about 550k. We also have a husband/wife owned S Corp biz which qualifies for 199a and makes about 750K. Solo 401k is setup with MBD Roth option. Marginal tax rate at least 35%. Thoughts on what to set as S Corp salaries and how to fund retirement accounts?
About 28% of what the S corp makes to maximize 199A, but you’ll likely need to pay even more than that to max out 401ks unless you do a MBDR.
To clarify, you suggest 28% of total income of S Corp as salaries for EACH of us? Or 28% of SCorp profits (ie after deductions) as salaries for each of us?
Scenario : Total 750k – 250k expenses = 500k profit.
28% total. Actually 28.6%. More info here:
https://www.whitecoatinvestor.com/section-199a-deduction-qbi-and-retirement-accounts/
Hi! I’m a recent pediatric dentist grad and new to the WCI. I’m in a similar situation to #2 where I have 2 W2 jobs where I make ~150,000 and a 1099 independent contractor job where I make ~50,000. I was wondering if I should open a solo 401k and make a mega back door Roth contribution from the 1099 job, or if it wouldn’t be worth the time and hassle for so little money?
Thank you! I appreciate all the great info you all share.
Only you can decide what your time and hassle is worth. You can certainly do it.
Thank you! I wanted to do it, but since it’s my first full year working I wasn’t sure how much of the 50k I would actually be able to put in the solo 401k, and how much I could contribute from that to my Roth.
And just to clarify, can I do the mega Backdoor Roth from a solo 401k through vanguard or would I have to use a separate entity like mysolo401k or rocketdollar?
I don’t think Vanguard’s cookie cutter plan allows them, no. You’ll need a different provider that charges a little more.