While year’s end is still the ideal time for tax planning for small business owners, there is still time to minimize your 2021 taxes. If you are reading this before filing your taxes for 2021, you can still maximize your Section 199A tax deductions for Qualified Business Income (QBI). Even if you have no idea what I’m talking about here, keep reading if you own a business (or have self-employment income) and want to reduce your income taxes for 2021.
As we make our way into 2022, it is better late than never to take steps to minimize your 2021 taxable income. This will help you to maximize the benefits of the 20% QBI tax deductions. As a financial planner working with many business owners, some of these tax-saving options can help you reach your long-term financial goals faster and easier.
The Basics of the Section 199A QBI Deduction
The Tax Cuts and Jobs Act (TCJA) of 2017 allow small businesses that operate as pass-through entities (think partnerships, S Corps, and even sole proprietors) to deduct 20% of their “qualified business income” (QBI). This valuable deduction is available for tax years 2018 through 2025, at least as it stands now. These (sometimes) generous deductions (like much of the TCJA) limited who could really get the maximum benefits. In this particular case, “service businesses” (think doctors, accountants, CPAs, financial planners, financial advisors) are not allowed to get the full 20% tax deduction if they have incomes above certain levels.
The applicable QBI threshold levels for 2021 are $329,800 (married filing jointly) or $164,900 (single tax filers), and the deduction is phased out for service business owners with incomes above these levels. If you own a service business and your taxable income exceeds $429,800 (married filing jointly) or $214,900 (single tax filers), you will not receive any benefit from the QBI tax deduction.
Keep in mind this is the net taxable income rather than gross income to your business, which is why your amazing financial planner and tax planning could help.
QBI Deductions And Pretax Retirement Plan Contributions
While most other tax strategies would have needed to be implemented before the year’s end, many retirement plans can still be funded during 2022 to help lower your 2021 taxes. Some can even be set up in 2022 for 2021.
With the QBI deduction in mind, you may be even more aggressive when it comes to funding your retirement accounts. There are likely two numbers to target each year. 1) The amount you NEED to save to retire comfortably. 2) The amount you can save to help retire comfortably AND maximize your tax savings.
Some common retirement plans for small business owners are the SEP-IRA and Solo 401(k). For 2022, you can potentially still set up and contribute 25% of your income to a SEP-IRA plan, with a maximum contribution of $58,000 for tax year 2021. If you and your spouse both work in the business, each of you may be able to contribute $58,000, assuming your business has enough income to support those contributions.
With a Solo 401(k), you can contribute as both the employee and employer, which may allow for larger pretax contributions. For 2021, you can contribute $19,500 as an employee, plus an additional $6,500 if you are age 50 or older. As the business owner, you can contribute a total of $58,000 minus the employee contribution. The total contribution could be as high as $64,500 in 2021 if the business owner is age 50 or older. Check with your financial planner about deadlines to set up and fund Solo 401(k) plans.
While the tax benefits of saving for retirement are huge over time for all business owners, they can be even more valuable for employers who are able to also qualify for the 20% QBI deduction. Contributing to a retirement plan could decrease your taxable income enough to help you get the full, or perhaps just a larger, QBI deduction for 2021 and beyond.
For a business owner with even higher incomes or one who really needs to play catch up for retirement, look at adding a Cash Balance Defined Benefit Pension Plan to your SEP-IRA or 401(k) profit-sharing plan. The contribution limits are above and beyond the number listed for the SEP and 401(k) and are also pretax. For 2021, the Defined Benefit Plan’s maximum contribution is $230,000 per employee. The maximum Defined Benefit Plan contribution per employee will increase to $245,000 in 2022.
When designed properly, a Cash Balance pension plan may allow for even larger contributions each year than the Defined Benefit pension plan. The deadline to set up a plan for 2021 has passed, but you can still set up and get the tax benefits of a Cash Balance plan for 2022.
Actual contribution limits will depend on how the Defined Benefit plan is set up, the age of the participants, as well as their income levels. Typically, plans are designed to provide a specific benefit at a specific time in the future. An actuary will help you work backward from the desired retirement plan benefit to determine the contribution needed for each participant of the Defined Benefit or Cash Balance plan each year. The business owner makes all contributions, so these plans typically work best for a successful business with fewer long-term employees.
Take the time now to make sure you have taken the proactive tax-planning steps to get the biggest QBI for your business in 2021.