2. The 20% Qualified Business Income Deduction
This one first appeared on 2018 tax returns and still has tax planners baffled, but only when income exceeds the threshold limits.
The 2019 qualified business income taxable income limits are $321,400 to $421,400 for married/joint filers and $160,700 to $210,700 for single filers.
Most small business clients with pass-through income (from LLCs, S corporations, partnerships and sole proprietorships) fall under these limits, so they all receive the 20% tax deduction, aka “the 199A deduction,” named for that section of the tax code.
A Roth conversion, though, can throw a monkey wrench into those plans, pushing taxable income over the qualified business income limits and eliminating the 20% deduction. Yet under one of the other quirky rules, a Roth conversion can actually increase the deduction.
The deduction in general is 20% on business income from any of those pass-through entities, as long as it doesn’t exceed the qualified business income limits. Unlike others, however, this deduction, does not reduce adjusted gross income, only taxable income. But another tax rule lowers the qualified business income deduction if taxable income (in excess of capital gains) is less than qualified business income. In this case, a Roth conversion can increase taxable income and in turn increase the qualified business income deduction. But you must be careful not to convert so much that it throws income over the limit where the deduction can be lost altogether. This is a delicate balancing act.
Once income exceeds the qualified business income limits, other complex tax rules come into play that take into account what type of business it is, the amount of W-2 wages and the amount of capital investment, and these can either knock out or allow the 20% tax deduction. The deduction becomes more valuable when business income is higher, so this is important for pass-through business income clients to assess, especially those clients close to the qualified business income limits. If the client has already been disqualified for the business income deduction because of the type of business or level of income, then the Roth conversion will have no effect, since the deduction was lost even before the funds were changed over.
3. Medicare Income-Related Monthly Adjustment Amount Charges
These should be known to most advisors and clients, but the interplay with Roth conversion income is often confusing because of the two-year look-back rule. In addition, for 2019, a new income-related monthly adjustment amount bracket was added for higher income Medicare enrollees. That bracket ($500,000 and above for singles, $750,000 and above for married/joint filers) increases the charges. However, the two-year rule makes it more difficult to project this charge’s effect on a Roth conversion. The charges are based on income from two years ago (that income, modified adjusted gross income, includes tax-exempt interest and untaxed foreign income). The 2019 limits apply to 2017 income that already happened. A Roth conversion in 2019 won’t impact the income-related monthly adjustment charges until 2021. If the charges will be an issue for a higher income client, then you need to plan two years ahead to see how a 2019 Roth conversion (along with other 2019 income) will impact the income-related charges in 2021.
4. Child Tax Credit Effect