United States

Tax reform, retirement plans and business ownership

Savings opportunity for owners requires new analysis

INSIGHT ARTICLE  | 

Business owners need to consider the impact tax reform has on the benefits of retirement plan contributions. For employees, the differences are typically minimal, however the affect on owners may not readily be seen at first glance.

From a tax savings perspective, when you compare 2017 to 2018 retirement plan limits you can see that the only changes are those mandated by the tax code’s inflation indexing provisions. For example:

Limit 2017 2018
401(k) elective deferrals $18,000 $18,500
401(k) catch-up contributions $6,000 $6,000
Maximum annual addition $54,000 $55,000
Maximum considered compensation $270,000 $275,000

 

Tax reform did lower individual income tax rates, for example consider the changes in taxes for the following samples of unmarried taxpayers1:

Taxable income 2017 income tax 2018 income tax Tax reduction
$150,000 $34,982 $32,090 $4,693
$350,000 $99,499 $98,190 $1,309
$550,000 $175,59 $171,040 $4,559

 

These lower tax rates make the current tax deduction one receives for contributing to a 401(k) plan somewhat less valuable. If an employee drops from a 28 percent to a 24 percent marginal tax bracket, then his or her $18,500 pretax contribution to a 401(k) plan is $740 less valuable in 2018 than it was in 2017. 

For an employee, the primary tax benefit for non-Roth savings is the shifting of income from a higher tax rate at the point of contribution to a potentially lower tax rate at the time of withdrawal. That income shift, along with the deferral of tax on the investment income in the plan and the benefits of a disciplined approach to savings, supports a conclusion that even considering the tax changes in effect, saving for retirement remains a valuable tax strategy in 2018. However, the new qualified business income deduction and the reduction in C corporation tax rates make this a very different analysis for business owners. These lower tax rates make the current tax deduction one receives for contributing to a 401(k) plan somewhat less valuable. If an employee drops from a 28 percent to a 24 percent marginal tax bracket, then his $18,500 pretax contribution to a 401(k) plan is $740 less valuable in 2018 than it was in 2017.

Impact of tax rate changes on business owners

The impact on the owner of a business at first may seem to be similar to that of an employee. If the sole-proprietor’s portion of the contribution to a cash balance plan sponsored by her business is $150,000, the federal tax deduction might have been worth $59,400 ($150,000 × 39.6 percent) to her. Now, in 2018, if she is in, at most, a 37 percent bracket, the deduction is less valuable, but not so significantly less valuable that the business would want to terminate the plan.

Tax reform, however, throws one more variable into the equation. Suppose she is a plumbing contractor and therefore eligible to, without limitation, claim the new qualified business income deduction. The qualified business income, or section 199A deduction, is a complex change in the tax law that needs substantial further guidance from the IRS—and the details of which are too complex for a discussion here. However, when looked at simply, it provides owners of certain pass-through businesses as well as sole-proprietors a 20 percent deduction against their qualified business income.

This new deduction changes the game dramatically.

  • Less valuable deduction: With the 20 percent deduction, the effective maximum tax rate on the contractor’s business income is now 29.6 percent (37 percent × 80 percent). That reduces the value of the $150,000 contribution from $59,400 in 2017 to $44,400 in 2018.
  • Less valuable tax deferral: If, at retirement, our contractor is in a 35 percent marginal tax bracket, any withdrawals that she makes in retirement will cost more than the value of the deduction claimed in 2018. A $150,000 withdrawal will cost $52,500 ($150,000 × 35 percent). That is $8,100 more than the value of the 2018 deduction.

On a net basis, our contractor may increase her taxes by contributing to the plan. Of course, the exact difference depends on the length of the deferral, future tax rates, earnings generated on the deferral, and the time value of paying that tax in the future instead of today.

Other reasons to adopt or continue a plan

There are reasons other than current tax savings for a business owner to sponsor a company retirement plan. From a business management perspective, the key benefit is that a retirement plan can attract and retain better employees. The business owner(s) personally benefit because a retirement plan, even with reduced tax savings, is still an effective financial vehicle that provides for wealth accumulation, diversification of assets (not everything tied to the business) and protection from creditors.

1 The sample taxpayer information assumes that after considering the year-to-year changes to adjusted gross income, exemptions, and itemized or standard deductions the taxpayers ended up with the same taxable income in 2017 and 2018.

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