Many specialty contractors are eager to find ways to reduce their taxable income. Be aware that the tax savings for some popular retirement account contributions may not be what you expect—certain business owners may benefit from forgoing a pre-tax deferral.
Pop Quiz:
You are a one-man, sole proprietor plumbing contractor in the state of Arizona. Your gross income after business expenses (and prior to any pre-tax deferrals) is $130,000.
Your tax preparer has informed you that $130,000 in taxable income puts you firmly in the 24% marginal federal income tax bracket for a single filer.
True or False?
For every $1 contributed to a SEP IRA, you will save $0.24 in federal income taxes.
Answer:
False.
You would save (defer, rather) $0.192 in federal income taxes for every $1 contributed to a SEP IRA. If a pass-through entity defers taxable income via a contribution to a retirement plan, the ‘free’ qualified business income (QBI) deduction is also reduced. As a result, you only receive 80% of the deferral benefit.
It is important to note that a deferral insinuates that you must pay the tax later at an unknown rate. If you forgo the SEP IRA contribution and instead contribute to a Roth 401(k), you will not reduce your taxable income. Instead, you will ‘lock-in’ a 19.2% federal income tax rate and can grow those funds tax-free.
*Qualified Business Income (QBI) deduction is subject to phaseout/elimination dependent on business-type and other variables.
This information is general in nature and is not meant as tax or legal advice. Tax laws are subject to change. Please consult your legal or tax advisor.