Business owners, pay attention: there are moments when converting a portion of your traditional IRA or 401(k) into a Roth can come with surprisingly low tax consequences.
When the Tax Cuts and Jobs Act of 2017 slashed the corporate tax rate, Congress wanted to ensure small business owners running pass-through entities didn't get left behind. Enter Section 199A: the Qualified Business Income (QBI) Deduction.
The Basics of the QBI Deduction
- Who Qualifies: Owners of pass-through entities, including S Corporations, partnerships, estates, trusts, and sole proprietorships.
- The Limitations: Depending on your income level and industry, your QBI deduction may be limited (the fine print gets complex, so please contact us directly for details on your specific situation).
- The Core Formula: The deduction is generally capped at 20% of the lesser of two numbers:
- Qualified Business Income (your net business profit, less some adjustments)
- Taxable Income minus Capital Gains
How the Formula Can Cap Your Savings
Imagine your business generates $100,000 in QBI, but for the year, you also report $75,000 in total Taxable Income and $50,000 in Capital Gains.
To find your deduction, compare 20% of both limits:
- 20% of Qualified Business Income: 20% of $100,000 = $20,000
- 20% of Taxable Income less Capital Gains: 20% of ($75,000 – $50,000) = $5,000
Because of your significant capital gains and other deductions, your QBI deduction is squeezed down to just $5,000 instead of the full $20,000!
The Roth Conversion Plot Twist
This gap is where an intentional Roth conversion creates an advantage. By intentionally adding taxable income via a Roth conversion, you expand the second limit and unlock more of your unused QBI deduction—effectively offsetting some of the tax cost of the conversion itself.
Let’s look at what happens if you convert $10,000 to a Roth under those exact same financial conditions:
Original Scenario | With $10,000 Roth Conversion | |
Taxable Income | $75,000 | $85,000 |
Taxable Income Less Capital Gains ($50k) | $25,000 | $35,000 |
QBI Deduction Allowed (20%) | $5,000 | $7,000 |
By adding $10,000 in income, your QBI deduction jumps by $2,000. The net result? You shifted $10,000 into a tax-free Roth, but effectively only $8,000 of that conversion is subject to tax.
The key advantage comes when the conversion amount remains within your existing marginal tax bracket. Because the additional income unlocks a larger QBI deduction, the effective tax rate you pay on those newly converted Roth dollars ends up significantly lower than your marginal bracket would suggest!
Is This Strategy Right for You?
If you own a pass-through business and realized sizable capital gains this year, evaluating a Roth conversion could yield significant long-term tax savings.
However, because this calculation involves multiple moving parts, executing it incorrectly can lead to overpaying taxes. Before making any moves, please consult your tax professional or reach out to us today to see if your numbers align for this strategy!