Many business owners may be aware of pass-through deduction but lesser of them may realize that they can utilize eligible retirement contributions to potentially gain a huge tax advantage on pass-through income.
“Pass-through” deductions, also known as Section 199A deduction was created by the Tax Cuts and Jobs Act (TCJA). It allows business owners who own a partnership, S corporation or sole proprietorship to deduct up to 20% on pass-through income.
There are some restrictions and limitations. For example, the taxable income thresholds for 2023 are as follows:
For married couples, if their taxable income is greater than $364,200, they may have a gradual phasing out of the 20% deduction as their income increases. Once their taxable income exceeds $464,200, they are not eligible for pass-through deduction.
One of best strategies is to maximize contributions to a retirement plan. For example, if a married couple who made $500,000 in taxable income and contributed $150,000 (or the maximum allowed amount) to a retirement plan, their taxable income was reduced to $350,000 which is below the threshold for married couples filing jointly.
Business owners with higher earnings can utilize this strategy to reduce their taxable income and thus qualify for a 20% pass-through deduction. Furthermore, this strategy can be applied to a wide range of retirement account types which include detailed benefit pension plans and defined contribution plans.
For business owners considering maximizing their retirement contributions (or possibly opening new retirement accounts) to take advantage of pass-through deduction credit, it is crucial to perform cost-benefit analysis as this strategy can come with greater administration cost from retirement accounts.
Also, please keep in mind that tax law may change, and new regulations can be passed at any time which may affect pass-through deduction in the future. Business owners should take the action to work on this strategy for the current business year.
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