While the optimal time for tax planning may have been at year’s end, there’s still time left to reduce your small business taxes for 2021, assuming you haven’t filed yet.
This blog explains the tax-planning strategies that can help reduce your 2021 taxable income. Below we provide guidance on maxing out your deductions to qualify for the full 20% qualified business income deduction.
Section 199A QBI deduction
The Section 199A deduction for QBI was established in the Tax Cuts and Jobs Act (TCJA) of 2017 and allows eligible small business owners and self-employed individuals to deduct up to 20% of their “qualified business income” for tax years 2018 through 2025.
Eligible entities include small businesses that operate as pass-through entities — partnerships, sole proprietorships, S-corporations and limited liability companies.
The QBI deduction is phased out for business owners with incomes over:
$164,900 … single tax filers
$329,800 … married filing jointly
The QBI deduction doesn’t apply to business owners with incomes over:
$214,900 … single tax filers
$429,800 … married filing jointly
Suggestions for small businesses
Here are some proactive tax-planning steps that can help you get the biggest QBI deduction for your small business in 2021.
Pretax retirement planning:
The tax benefits of saving for retirement are fruitful over time for business owners, but these benefits can be even more valuable for those who are able to also qualify for the 20% QBI deduction. Contributing to a retirement plan could lower your taxable income enough to help you receive the full, or even a larger, QBI deduction for 2021 and even after. Here are a few tips:
Be aggressive with contributions: Maximize your QBI deduction by making the maximum contributions to traditional retirement plans and health savings accounts. Certified financial planner David Rae advises that entrepreneurs target two numbers. The first one is the amount you need to save to retire comfortably, and the second is the amount you can save to help retire comfortably and maximize your tax savings.
Some common retirement plans for small business owners: While most other tax strategies are required to be implemented before the end of 2021, there are retirement plans that can still be funded during 2022 to help decrease your 2021 taxes. And some can even be set up in 2022 for 2021. Small-business owners can consider establishing a SEP-IRA, fund a 401(k) from both employees and the employer sides of the aisle or fund a one-participant 401(k), commonly called the Solo 401(k).
With a SEP-IRA, you can contribute 25% of your income, with a maximum contribution of $58,000 for tax year 2021. And in the event your spouse also works in the business, each of you may be able to contribute $58,000. Because you aren’t required to contribute to the account every year, you could establish the plan primarily to take advantage of the potentially temporary QBI deduction, and stop contributing or reduce contributions if Congress allows the 199A deduction to expire after 2025.
The Solo 401(k) allows you to contribute to the capacities of both employee and employer, thus letting you make larger pretax contributions. For 2021, you can contribute $19,500 as an employee, and a catch-up contribution of an additional $6,500 if you are age 50 or older. And as the business owner, you can contribute a total of $58,000, less the employee contribution. However, the total annual contribution cannot exceed $64,500 for the 2021 tax year including the catch-up contributions.
Amp up tax savings with a cash balance plan:
Cash balance plans provide small business owners a way to save more than the traditional 401(k) or SEP-IRA, lowering taxable income significantly. These are a cross between a traditional defined benefit pension plan and a defined contribution plan, such as a 401(k). That means the $58,000 yearly contribution limit for 2021 is inapplicable.
The contribution limit for cash balance plans is based on the amount the participant may receive upon retirement, meaning it varies based on age. Employers often contribute an established portion of a participant’s salary to the plan every year, and the latter’s account is provided an interest credit annually.
The tax benefits with the cash balance plan are enormous: As previously stated, the cash plan contribution limit will generally be significantly higher than the annual defined contribution plan limit. Depending on your income and age, the lump sum contribution limit under the plan is $3 million in 2021 subject to certain conditions.
The deadline to set up a cash balance plan for 2021 has passed: The cash balance defined benefit pension plan must be set up during the fiscal year, but you have substantially more time to fund it. To get the deduction for 2021, you can make contributions to fund your cash balance plan by the due date of your tax return which is April 18, 2022. In case you have filed for an extension on your 2021 tax returns, you have until October 17 to fund the plan.
