Why the QBI May Make This A Good Year for You to Complete a Roth Conversion
by John Cooney on Oct 8, 2018
A key provision of the 2017 Tax Cuts and Jobs Act (TCJA), Section 199A, commonly referred to as the Qualified Business Income (QBI) deduction, allows non-C Corp business owners the opportunity to deduct a percentage of their net business income to lower their overall taxable income. This deduction, when combined with the lower tax brackets put in place by the TCJA could make this the right time for you to do a Roth conversion.
What is the QBI deduction?
The QBI deduction states that all business owners, except those for a C Corporation, can deduct 20% of their net business income or total income (depending on which is lower) when they file their taxes for the year. The deduction is taken on the business owner’s personal income tax return. An oddity to the deduction is that it is not quite an above the line deduction, nor is it below the line either. An above the line deduction is a deduction that is taken before a person’s Adjusted Gross Income (AGI) is calculated. Below the line deductions are then used to lower the AGI to the taxpayer’s Taxable Income (TI), which is then used to assess the tax liability for that filer. The distinction is important, because below the line deductions are only taken when a taxpayer chooses to itemize their deductions rather than taking the standard deduction. With the standard deduction doubling as part of the TCJA, fewer people will be itemizing, i.e. taking below the line deductions in 2018. However, even though the QBI is not an above the line deduction, it can still be used to lower your taxable income even if you choose the standard deduction, which is why it is kind of in-between an above and below the line deduction. Let’s look at an example to see how it works. Bob and Marie are a two-income couple, with Marie earning $75,000 a year In W2 wages, and Bob making a net income in his small business of $25,000. Together, their total income equals $100,000 and they have no above the line deductions, making their AGI also $100,000. They are however, eligible for the QBI deduction based on Bob’s business earning a net profit of $25,000. The business income is used because it is the lower of the taxable income and the net business income. The QBI deduction will allow Bob and Marie to deduct 20% of Bob’s business net income, or $5,000. The QBI deduction, combined with the standard married filing jointly (MFJ) deduction of $24,000 brings their taxable income down to $71,000, putting them in the 12% tax bracket and incurring a total tax liability of $8,139.
Total Income = $100,000
Above the line deductions = $0.00
Adjusted Gross Income (AGI) = $100,000
Standard Deduction (MFJ) = -$24,000
QBI = -$5,000
Taxable Income = $71,000
Taxes Owed = $8,139
Too easy, right? Now, the IRS has put some limits on the QBI deduction, most notably, an income limit. For a taxpayer filing as single, as long as their taxable income is below $157,500, then they can take the full 20% deduction. If it is between, $157,500 and $207,500, they are eligible for a partial deduction of the 20%. For those filing a joint return, in order to be eligible for the full deduction they must be under $315,000 in taxable income, and between $315,000 and $415,000 for a partial. If taxable income for a single filer is above $207,500 or $415,000 for a joint filer, and they are not a specified service trade or business,* then they still may be able to take a deduction, but the calculation gets much more complicated. If you fall into this category, I recommend you talk to a financial planner, enrolled agent, or CPA to see if you can still claim the deduction.
What does the QBI have to do with a Roth Conversion?
The general wisdom in guiding whether or not to perform a Roth conversion is that it is a viable option in those years where your taxable income is low. Deducting 20% of your net business income will very obviously make your taxable income lower for the year. This deduction, combined with the lower tax brackets introduced with the TCJA can make a Roth conversion a very attractive option for taxpayers. Let’s go back to the example of Bob and Marie. All of the facts will remain the same, only in this scenario, in addition to the W2 wages and net business income, Bob and Marie will also convert $5,000 from their traditional IRA to a Roth IRA, increasing their total income to $105,000. Marie’s W2 wages ($75,000) + Bob’s business income ($25,000) + Roth conversion ($5,000). After taking the standard deduction ($24,000) and the QBI deduction ($5,000), their taxable income will be $76,000 and their tax liability for the year will be $8,739.
Total Income = $105,000
Above the line deductions = $0.00
Adjusted Gross Income (AGI) = $105,000
Standard Deduction (MFJ) = $-24,000
QBI = $-5,000
Taxable Income = $76,000
Taxes Owed = $8,739
As you can see from the example, by making the conversion, Bob and Marie incur an additional $600 in taxes owed. However, since the funds are now in a Roth account they will grow tax free, meaning any earnings on the $5,000 will not be taxed when taken out in retirement! How much can this potentially benefit them? Let’s take a look, assuming that they leave the money in the account for another 20 years, and the investment earns an annual return of 5% over that time.
As the chart shows, by doing the conversion, and paying the taxes up front, even if Bob and Marie were in a lower tax bracket when they withdrew the conversions, they would end up paying more in taxes when withdrawing from the traditional IRA. This does not even take into account some of the other advantages of the Roth, like no required minimum distributions or penalty free access to contribution amounts! All in all, it can be a very beneficial move for a taxpayer to make.
Just a couple final points related to the QBI deduction. First, the lower tax brackets and the QBI deduction itself, are both part of the provisions of the TCJA that will expire in 2025. While Republicans have put forth a bill to make them permanent, it has not yet passed, so this opportunity may not be available after 2025. Secondly, another provision of the TCJA eliminated the option to recharacterize a Roth conversion. In the past, if a taxpayer changed their mind about a Roth conversion, they had up until the time they filed their taxes to recharacterize the conversion back to a tax-deferred account. This is no longer an option, a Roth conversion, once completed is now irrevocable.
What do you think? Are you a business owner that will be claiming a QBI deduction this year? Do you have tax-deferred retirement plans that you want to convert? This may be the year where it makes sense to take advantage of the lower tax brackets put in place by the TCJA, pay taxes today, and set-up your future self to reap the tax rewards.
Interested in taking advantage of the QBI?
* The following businesses have been deemed Specialized Services, Trade, or Business and are ineligible for the QBI deduction when their income exceeds the phaseout limits:
- Actuarial Sciences
- Performing Arts
- Financial Services
- Brokerage Services
- Investing and Investment Management
- Dealing in Securities, Partnerships, or Commodities
- Any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners (celebrity endorsements/appearances)