Planning Practicum

Prescription Without Diagnosis is Malpractice

Risk management is all about diversification, not only in asset allocation, but also in asset location

by Herbert K. Daroff, J.D., CFP®, AEP®

Mr. Daroff is a contributing editor to Advisor Magazine, and is affiliated with Baystate Financial Planning, in Boston.
Visit www.baystatefinancialplanning.com

I received this question the other day from one of our advisors (names changed to protect the clients, the advisor, and me). Abigail is working as a therapist, currently as a sole proprietor. I have the following questions regarding her practice:

How should she structure her business?

  • I am leaning towards an LLC but would like to get your expertise on this
  • What would be the optimum retirement savings plan for Abigail to implement?
  • My initial thought was an individual 401(k) but again, I would appreciate any input you could provide
  • Abigail is 55, married, and resides in Massachusetts. Her annual income is approximately $90,000. She plans to retire at age 62

Here is my response:

LLC is likely a good choice for her for creditor protection. However, let’s discuss if Qualified Business Income (QBI) can benefit her. What is her spouse’s income?

  • The income and QBI discussion will help determine whether she should fund retirement pre-tax or after-tax
  • They may be in a relatively lower tax bracket now than they will likely be in 7-years (when we revert to the 2017 rules, or something else)
  • Solo(k) may be a good choice. However, let’s start with diagnosis before we prescribe
  • How much of her income would she like to shelter? Depending on her spouse’s income, she may want to set aside a significant portion of her income
  • Roth and/or Life Insurance Cash Value may be better choice than taking a tax deduction now in a relatively lower tax bracket and then taking distributions later in what may be a higher tax bracket (even if lower income)

On the surface, LLC and Solo(k) would seem like the right choices. However, further diagnosis (analysis) may lead us to a different prescription (recommendation)

In 2019, even if her practice is deemed to be a specified service business, if the couple’s combined income is less than $321,400 (married filing jointly), then 20% of her income could be deducted. So, let’s assume that her spouse also earns $90,000 as an employee for some other business:

Total Income for the Couple:             $180,000

            QBI Deduction for her                        ( 18,000) = 20% of her $90,000

                                                                        $162,000

            Standard Deduction:                           ( 24,400)

                                                                        $137,600

 

            TAX:                                                  $ 21,989 22% bracket up to $168,400*

 

FROMTORATE TAX
$0$19,40010%$1,940$1,940
$19,400$78,95012%$7,146$9,086
$78,950$137,60022%$12,903$21,989

 

*Tax Brackets for Married Filing Jointly in 2019:

FROMTORATE TAX
$0$19,40010%$1,940$1,940
$19,400$78,95012%$7,146$9,086
$78,950$168,40022%$19,679$28,765
$168,400$321,45024%$36,732$65,497
$321,450$408,20032%$27,760$93,257
$408,200$612,35035%$71,453$164,710
$612,35037%

$21,989 tax on $180,000 of income is only $12.2%

Does taking a current income tax deduction make sense?

It does, if they will be in a lower income tax bracket when they take distributions. Ask your clients, “Over the next 10, 20, 30 years, do you think income tax brackets will be going down, staying the same, or going up?” What do you think?

Even if he makes $30,800 more (for a total of $120,800), they would still be in the 22% marginal income tax bracket for 2019. If he makes $150,000 ($60,000 more than the assumed $90,000 above), for example, their total income would increase to $197,600 putting the last $29,200 into a 24% marginal income tax bracket.

Let’s assume that she saves $25,000/year ($19,000 401(k) limit plus $6,000 being over age 50) for the next 7 years at an assumed 5%. How much will she net after income taxes? That depends on the income tax rate during distribution.

CONTRIBUTIONPRE-TAX5%
Year1$25,000$26,250
2$25,000$53,813
3$25,000$82,753
4$25,000$113,141
5$25,000$145,048
6$25,000$178,550
7$25,000$213,728
Total$175,000
DISTRIBUTION
Tax Rate15%$181,669
20%$170,982
25%$160,296
30%$149,609

 

At a tax rate of more than 18.12% during distribution, she will net less than the $175,000 she contributed (based on these assumptions)

And, we have only discussed Federal income tax rates.

What if she, instead, funded the same $25,000 but with after-tax dollars? That would be $21,250 in a 15% current income tax bracket.

CONTRIBUTIONPOST-TAX5%
Tax Rate15%
Year1$21,250$22,313
2$21,250$45,741
3$21,250$70,340
4$21,250$96,170
5$21,250$123,291
6$21,250$151,768
7$21,250$181,669
Total$148,750
DISTRIBUTION
Tax Rate15%$181,669
20%$181,669
25%$181,669
30%$181,669

 

If the income tax rate is the same during distribution as it is during contribution, then the net after tax results for a traditional 401(k) are the same as for a Roth 401(k).

If the income tax rate during distribution is higher than it was during contribution, then the Roth 401(k) will produce higher net after tax results than the traditional 401(k).

Of course, we have no idea what Congress may choose to do, at any time. They might adopt a national sales tax and reduce the income tax. If so, then the traditional 401(k) will produce higher net after tax results than the Roth 401(k).

Risk management is all about diversification, not only in asset allocation, but also in asset location. Based on what you and your client think are the odds of higher, lower, or the same income tax brackets during distribution as they are during contribution will dictate how much is allocated pre-tax to traditional 401(k) and how much after-tax is allocated to Roth 401(k) and/or to life insurance cash value. Remember, in essence, term insurance plus a Roth produces results that are quite similar to cash value life insurance. For those clients who are younger than 59½, the cash value in permanent life insurance is available without a 10% tax penalty. ◊