One of the biggest changes of the new tax law is that it now provides for a flat 21% tax rate for corporations. Without more changes this would have been a problem for pass-through entities (if companies are taxed at a lower rate than individuals, the pass-through scheme doesn’t work). To solve this problem, the new law provides that business income that passes through to an individual from a pass-through entity and income attributable to a sole proprietorship will be taxed at individual tax rates less a deduction of up to 20% to bring the rate lower. Unfortunately, this may create some unintended consequences and a disincentive for pass through business owners to contribute to or even maintain a qualified plan because it may increase the taxes paid on amounts contributed to a qualified plan.
Please note, the disincentive discussed herein does not affect everyone. Those businesses and people in fields health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services with income above a certain amount or amounts paid to an S-corporation shareholder that are on the Form W-2 (i.e., constitute reasonable compensation for services) are not subject to these rules.
Using the following example and assuming we have $100,000 of pass through income:
** This 20% deduction means that the effective tax rate on the net income from the business is 32% x 80% (i.e., the portion of the income that is subject to tax after the 20% deduction), or 25.6%.
This means that under the new law we save $25,600 in taxes by contributing $100,000 to a qualified plan rather than taking it straight into income.
The problem arises when we want to take a distribution because the distribution is subject to tax at the full individual rate. That means in our example, at a 32% tax rate, we would pay $32,000 in taxes at distribution on the $100,000 original contribution. That is $6,400 more than the tax savings we received for making the contribution. In other words, in our example, we don’t just defer taxes by contributing to the plan; we actually increase our taxes by $6,400 (about 20%)!!
Now it’s hard to tell if this increase in taxes is offset by the tax free buildup of earnings within the plan, but one has to ask whether pass through owners should make deferral contributions in the form of Roth contributions. Also, there are other reasons to have a retirement plan, including attracting and retaining staff, helping people prepare for retirement, and the sheltering of the funds from creditors but it makes you wonder whether small business owners ultimately fold up their plans and rid themselves of the associated costs and administrative hassle when they understand this unintended consequence.