QBI and Solo 401(k) Deductible Contributions - Do they Still Make Sense?

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MB1
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QBI and Solo 401(k) Deductible Contributions - Do they Still Make Sense?

Post by MB1 » Sat Oct 12, 2019 7:09 pm

Is there a consensus whether deductible (non-Roth) contributions still make sense for solo 401(k)s for individuals whose tax situation is such that they will have, under the new tax law, their Qualified Business Income (QBI) deduction reduced for each dollar of deductible 401(k) contribution that they make. I would think that for most people in that tax situation such deductions do not make sense given that you are giving up the 20% QBI deduction and, even given the benefits of the tax deferral, it would be hard to make that 20% up. In other words, I would think that you would be better off taking whatever money you would, under the old tax regime, have put in a 401(k) as a deductible contribution and (assuming a Roth 401(k) contribution is not an option) simply put that same money in conventional non-retirement investments.

In other words, it seems that, for many of us, the new tax law makes non-Roth 401(k) contributions pointless or counterproductive. Am I missing something? Maybe with a long enough time horizon the de facto 20% penalty will be overcome by the long term effects of tax deferral. I have never seen a helpful discussion of this issue, which presumably affects a lot of small businesses.

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grabiner
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Re: QBI and Solo 401(k) Deductible Contributions - Do they Still Make Sense?

Post by grabiner » Sat Oct 12, 2019 7:25 pm

A Roth may be better than an 80%-deductible 401(k), but a taxable account is unlikely to be better.

Say that you are in a 24% tax bracket. It costs you $8040 to put $10,000 in the QBI-affected 401(k) (since you get a 24% deduction on $8000). If you withdraw in the same 24% bracket, you get 76% of the pre-tax growth of $10,000, equivalent to the tax-free growth on $7600. Thus you lose 5.5% compared to a tax-free investment.

Unless you have a very short time horizon, you expect to lose more than 5.5% of the value of a taxable investment to taxes. If you invest in bonds, a 25% gain loses 6% to the 24% tax, actually slightly more because of compounding. If you invest in munis, you take a similar loss from the difference between muni and taxable yields. If you invest in stocks, a 90% gain loses 6% to the 15% tax, and you also lose more because of compounding on the dividend taxes. While 90% seems like a lot, it is just eight years of compounding of 8% returns, and you shouldn't be investing in stock if you have a time horizon less than eight years.
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MP123
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Re: QBI and Solo 401(k) Deductible Contributions - Do they Still Make Sense?

Post by MP123 » Sat Oct 12, 2019 9:36 pm

It depends on your AGI too.

If you're over the $415k phase out and in a specified service business then you don't get the QBI deduction anyway and your i401k contribution makes sense.

In some cases the contribution might lower your AGI enough that you became eligible for at least a partial QBI deduction or less of a phase out if you're in the phase out range. Some tricky math there.

Under $315k with a full QBI deduction allowed I think it becomes more questionable.

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Re: QBI and Solo 401(k) Deductible Contributions - Do they Still Make Sense?

Post by Spirit Rider » Sat Oct 12, 2019 9:46 pm

Like most determinations of pre-tax vs. Roth there is no one size fits all answer. The QBI deduction just puts a 20% finger on the current tax rate vs future tax rate determination. Then you couple that with personal facts, circumstances and choice.

It mostly affects situations where the current vs. future tax rates are the same or indeterminable within a narrow range. Most people eligible for the QBI deduction would be better with post-tax Roth designated contributions vs. pre-tax employee deferrals that reduce their QBI.

In many circumstances it does not make sense to simply give up pre-tax employer contributions. However, it makes custom one-participant 401k plans with available Mega Backdoor even more valuable for moonlighting activities. In many moonlighting circumstances the individual is maximizing their employee deferrals through their primary W-2 401k plan.

Therefore, they are only left with 20% of self-employed earned income (business profit - 1/2 SE tax) pre-tax employer contributions reducing their QBI. The employer contribution reduces compensation reducing the annual addition. At lower levels of self-employed earned income that doubly reduces employee after-tax contributions. In that case they are able to make greater total contributions by making 100% employee after-tax contributions and have no reduction in QBI.

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