The SEP-IRA has been a key retirement tool for self-employed and 1099 musicians, but its value just got unexpectedly reduced last month, buried in the details of a 249-page release of new IRS regulations. I’m afraid that many self-employed musicians who read this may want to fund a different type of retirement account or may decide to stop their SEP contributions altogether going forward. If you’re a W-2 musician, this doesn’t apply to you, and if you are strictly a W-2, you weren’t eligible for a SEP anyways.
The new regulations don’t directly change a SEP contribution – it’s still a tax deductible contribution. Self-employed musicians are also eligible for a new 20% tax deduction, called the Qualified Business Income or QBI deduction, officially IRC Section 199A. The QBI Deduction is new for 2018 as a result of the Tax Cuts and Jobs Act put into law in December 2017.
The QBI Deduction is available to pass-through entities, including S-corporations, LLCs, and sole proprietors. You do not have to be incorporated, anyone with self-employment income (including 1099 “independent contractor”) is eligible. For “Specified Service Businesses”, including performing artists such as musicians, the QBI deduction is phased out if your income is above $157,500 (single) or $315,000 (married) for 2018.
What was a surprise announcement in the January 2019 regulations, some 13 months after Congress signed the new law, is that all self-employed people have to subtract any “employer paid retirement contributions” from their Qualified Business Income. It was previously thought this would only apply to S-corporations. This was not mentioned or hinted at in the legislation or in the regulations the IRS published in August. In fact, many tax software programs are having to be rewritten because of the January announcement. The SEP-IRA, even for a sole proprietor, is considered a type of employer-sponsored retirement plan, even though the employer and the employee are the same person.
It may be easiest to explain this with an example. Let’s say you make $60,000 as a self-employed musician and choose to contribute $10,000 to a SEP IRA. (In this example, I am assuming that your taxable income and your Qualified Business Income are the same, but in some cases, they will be different.) Now, instead of getting the 20% deduction on the $60,000 of Qualified Business Income, worth $12,000 off your income, you have to subtract your SEP contribution of $10,000 to reduce your QBI to $50,000. Now your QBI deduction will be $10,000, $2,000 less than if you had not made the SEP contribution.
Your SEP contribution reduced the value of your QBI deduction by $2,000, so instead of adding a $10,000 benefit, your SEP contribution only increased your deductions by $8,000. Another way of looking at this: if you are eligible for the QBI, you are only getting 80% of the value of a SEP Contribution, but 100% of your SEP contribution will be taxable when you withdraw it in the future.
And that’s a problem. The $10,000 you contributed to a SEP only provided an increase of $8,000 in deductions, but the full $10,000 will be taxable when you withdraw it later in retirement, plus the tax on any growth. Who wants to get an $8,000 deduction today and immediately have a $10,000 future tax liability?
You might pay less in lifetime taxes by not making the SEP contribution, receiving 100% of the QBI deduction and then investing your $10,000 in a taxable account. The growth of the taxable account, by the way, could be treated as long term capital gains, which for most taxpayers is at a lower rate than the ordinary income rates applied to growth of your SEP (when withdrawn).
There are three additional solutions which you might consider rather than a funding SEP, given this new rule.
1. Traditional IRA. The Traditional IRA contribution will reduce your personal taxes, unlike a SEP, which is considered an employer sponsored plan. The SEP reduces the amount of your QBI deduction, but the Traditional IRA does not. However, there are two issues with the Traditional IRA:
- The contribution limit is only $5,500 for 2018 ($6,500 over age 50). With a SEP, you could contribute as much as $55,000, ten times more than a Traditional IRA.
- If you or your spouse are covered by any employer retirement plan, your eligibility to deduct a Traditional IRA contribution depends on being under income limits. (Details here.)
If you are single and are not covered by any employer plan (or married and neither spouse is eligible for a company plan), then there are no income restrictions on a Traditional IRA. And if you were planning on contributing less than $5,500 to your SEP, just skip the SEP altogether and fund a Traditional IRA so you can receive the full QBI deduction.
If you are eligible for both a Traditional IRA and a SEP, I would always fund the IRA first to the maximum, and only then make a contribution to the SEP.
2. Roth 401(k). A Traditional 401(k) or Profit Sharing Plan, like a SEP, can also land you in the penalty box for the QBI as a self-employed person. However, if you set up an Individual 401(k) plan that allows for Roth 401(k) contributions, then you will receive the full QBI deduction, even if you put $18,500 into your Roth 401(k).
Of course, you won’t get a tax deduction for the Roth contributions you make, but that account will grow tax-free going forward, which is a lot better than a taxable account. It’s a great option if you anticipate being in the same or similar tax bracket in retirement as you have today. The only problem is that unlike a Traditional IRA, you cannot establish a 401(k) today for the previous year (2018).
But you can establish one for this year, and if you’d like to do so, I can help you with this.
3. Spouse’s 401(k)/IRA. If you are self employed, but your spouse has a regular W-2 job, have your spouse increase their 401(k) contributions through their employer. That won’t ding your QBI Deduction and will reduce your joint taxable income dollar for dollar. If your spouse is eligible for a Traditional IRA – including a Spousal IRA if they do not have any earned income – that would also be preferable to having the self-employed spouse fund a SEP-IRA.
I do not want to suggest anything to discourage musicians from saving for retirement! But when one type of retirement account will reduce other tax deductions, I want to make sure that all my clients are informed to make the best choices for their situation. Feel free to email or call me if you’d like more information.
This article does not offer or imply individual tax advice; please consult your tax professional for information regarding your personal situation.