By Robert Klein, CPA
As stated in the introduction to my last Retirement Daily article, “Should You do a Roth IRA Conversion After Age 62?,” Roth IRA conversions are an excellent tool for optimizing after-tax income throughout retirement when done strategically as part of a holistic retirement income plan. The timing and amount of Roth IRA conversions needs to be carefully analyzed as part of a multi-year, or staged, Roth IRA conversion plan.
The article makes a case for accelerating the execution of a Roth IRA conversion plan given the backdrop of current historical low federal income tax rates and wide tax brackets favoring higher conversion amounts through 2025. While this strategy often makes sense, there are situations where reduced income tax savings can offset potential long-term benefits otherwise achievable with larger conversion amounts in a particular year.
Watch Out for the QBI Minefield
One situation where income tax savings can be reduced or eliminated by income from Roth IRA conversions comes into play with eligible owners of pass-through entities. If you’re an owner of a profitable sole proprietorship, Subchapter S corporation, or partnership, you’re probably familiar with the qualified business income, or QBI, deduction that became an important part of income tax law beginning in 2018.
The QBI, or Internal Revenue Code Section 199A, deduction provides owners of these types of entities with a tax deduction of the lesser of (a) 20% of the individual’s qualified business income or (b) 20% of taxable income minus net capital gains. The QBI deduction is a special deduction that's unaffected by above-the-line deductions, itemized deductions, or the standard deduction. Like current favorable income tax rates and wide tax brackets, the deduction is scheduled to sunset after 2025.
Service Business QBI Income Limitations
The QBI deduction is potentially reduced or eliminated by income limitations for individuals who fall under the category “specified service trade or business” (SSTB). This includes a trade or business involving the performance of services in 11 specified fields: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investment and investment management, trading, and dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees.
The income limitations for SSTB individuals in 2020 range from $163,300 to $213,300 for single filers and $326,600 to $426,600 for joint filers. Income limitations are essentially taxable income before the QBI deduction. The QBI deduction phases out beginning at the lower respective income levels and is eliminated at the top thresholds.
There’s potentially a lot at stake if you can keep your taxable income below the applicable income thresholds. Maximum QBI deductions are currently $32,660 ($163,300 x 20%) for single individuals and double this amount, or $65,320 ($326,600 x 20%), for joint filers.
QBI Roth IRA Conversion Example
This brings us to our question du jour: How can a Roth IRA conversion reduce or eliminate a QBI deduction and associated income tax savings? The best way to illustrate this is with a multiple-case example.
In our example, we have two individuals, Jim and Sheila, who are both attorneys unrelated to each other with identical employment income of $351,400. Jim is an associate attorney who receives a W-2. Sheila is a general partner in a law firm and receives a K-1 reporting her share of the firm’s income. Jim and Sheila take the standard deduction of $24,800 and use married filing joint tax status.
Case #1 – Jim: W-2 of $351,400
Jim receives a W-2 in the amount of $351,400. As an employee, Jim isn’t entitled to the QBI deduction. His taxable income is $326,600. Jim’s federal income tax liability, including Medicare tax on high-income taxpayers of $913, is $67,456.
Case #2 – Sheila: K-1 of $351,400
Sheila receives a K-1 in the amount of $351,400. As an owner of her law firm, Sheila is entitled to a QBI deduction in the amount of $65,320. Her taxable income is $261,280. Sheila’s federal income tax liability is $50,866, or $16,590 less than Jim’s federal tax of $67,456.
Case #3 – Sheila: K-1 of $351,400 and Roth IRA Conversion of $50,000
The facts in Case #3 are identical to those in Case #2 with one difference. On March 23rd, after the Dow Jones declined 38.4% from its all-time high of 29,569 on February 12th to a year-to-date low of 18,214, and knowing that Sheila and her husband are paying federal income tax at a historically low rate, Sheila did a Roth IRA conversion in the amount of $50,000.
Sheila’s QBI deduction decreased from $65,320 in Case #2 to $17,570 as a result of the QBI limitation on specified service trade or business individuals, increasing her taxable income from $261,280 to $359,030. This increased Sheila’s federal marginal tax rate from 24% to 32% and her federal income tax liability from $50,866 to $76,921. The difference of $26,055 represents a 51% increase.
Don't Disqualify Your QBI Deduction with Excess Roth IRA Conversions
What appeared to be a timely move on Sheila’s part, i.e., doing a sizable Roth IRA conversion following a 38% decline in the stock market, with associated elimination of income tax liability on future appreciation of her conversion while in a historically low tax bracket, proved to be ill-advised, at least in the short run.
$48,000, or 73%, of Sheila’s otherwise allowable QBI deduction was eliminated by doing a Roth IRA conversion of $50,000, resulting in an increase in taxable income of $98,000. The increase in Sheila’s income tax liability of 51% significantly exceeded her marginal tax rate of 24% without the conversion and 32% with the conversion.
In Sheila’s defense, it’s possible that when she did her conversion on March 23rd, her projected 2020 K-1 income may have been much less than $351,400, resulting in a higher projected QBI deduction.
Illustrate Multiple What-If Scenarios
If you’re a profitable service business owner, you should balance the strategy of accelerating income to take advantage of low tax rates in effect through 2025 against the potential phaseout and loss of the QBI deduction. This especially applies to large Roth IRA conversions that can’t be offset with losses and other deductions such as a rental property passive loss carryforward when the property is sold.
Although I didn’t illustrate it, there are situations where it makes sense to increase taxable income in order to increase the QBI deduction and reduce federal income tax liability. The lesson to be learned is that it’s important to do income tax planning using multiple what-if scenarios to minimize tax liability and increase the longevity of after-tax retirement income. This applies to QBI as well as other complicated tax planning situations.
About the author – Robert Klein, CPA
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the writer and publisher of Retirement Income Visions™, a blog featuring innovative strategies for creating and optimizing retirement income that Bob created in 2009.
Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs.
Retirement Income Center has established relationships with various highly respected professional organizations and platforms to provide the firm’s clients with its comprehensive array of fee-based planning, management, and protection services.