The Hidden Limit on Your Qualified Business Income (QBI) Deduction

And how independent contractors, real estate professionals, and small business owners could be leaving money on the table

What is the QBI Deduction and Who Qualifies?

The Qualified Business Income (QBI) deduction, also known as the Section 199A deduction, is one of the most valuable tax breaks available to self-employed individuals. This deduction, which came from the 2017 Tax Cuts and Jobs Act, allows owners of pass-through businesses (1099 contractors, sole proprietors, partnerships, and S Corps) to deduct up to 20% of qualified business income on their federal tax return.

To put this in perspective, let’s say a hypothetical realtor client has net profit on their Schedule C of $150,000. After removing one-half of self-employment taxes (as required by 199A regulations), QBI for the year is $138,525. With a 20% QBI deduction, they’d receive a $27,705 deduction – an opportunity that didn’t exist prior to 2017. As a California resident in a 30% combined tax bracket, that deduction could save over $8,300 in income taxes.

*The above example was created for illustrative purposes only and does not represent tax advice.

That is significant tax savings and a powerful tool for many self-employed individuals, but it doesn’t come without a catch: complexity. If the legislation were as straightforward as the above example, this article probably would not need to have been written. The reality is that IRC Section 199A is nuanced, and careful planning is required to ensure you’re taking advantage of the full deduction.

The Taxable Income Trap: Why 20% Isn’t Always 20%

In working with independent contractors and small business owners, one of the more common gaps I see is that they’ve unintentionally limited their QBI deduction by overlooking how taxable income factors into the calculation.

Taken directly from the IRS:

“The deduction is limited to the lesser of the QBI component… or 20 percent of the taxpayer's taxable income minus net capital gain.”

So even if you generate a high amount of QBI, your actual deduction may be capped by your taxable income. For households whose income is predominantly comprised of QBI, standard deductions, itemized deductions, and pre-tax retirement contributions can easily push taxable income well below QBI and significantly shrink the deduction they may have been expecting.

Planning Around the Gap Between QBI and Taxable Income

Here’s where it gets interesting: If your taxable income is less than your QBI, every additional dollar of ordinary income you report could unlock a 20% deduction on that same dollar.

Said another way, only 80 cents of that additional income is effectively taxed.

Now, there may be valid reasons not to generate more income in the current year—but for many of the clients I work with, it’s well worth the tradeoff, especially given today’s historically low tax rates.

Unlock Your Full QBI Deduction with Roth Conversions

So how do you create more non-QBI ordinary income without picking up a shift driving Uber? And how do you know how much additional income you should pick up?

One of the most precise and strategic methods of maximizing the QBI deduction and creating ordinary income is through Roth Conversions.

A Roth conversion is the process of moving money from a pre-tax retirement account (like a traditional IRA or 401(k)) into a Roth IRA, where future growth and withdrawals can be tax-free. While this move creates ordinary taxable income in the year of conversion, it can be a powerful planning tool, especially for households without W2 income.

Because the QBI deduction is limited by taxable income, adding just the right amount of income through a Roth conversion can unlock a larger QBI deduction, essentially turning one strategic tax move into two tax wins. We can also time the conversion toward the end of the year, when QBI and taxable income projections are clearer, and calculate the ideal conversion amount to precisely maximize the deduction without pushing into higher tax brackets (or going over QBI).

Strategic Qualified Business Income Planning in Action

Let’s go back to our hypothetical realtor client with $150,000 of net Schedule C income. After accounting for the deduction of one-half of self-employment taxes (let’s say $11,475), their QBI for the year is $138,525.

This realtor is married and filing jointly, but thanks to mortgage interest, property taxes, and other deductions, their taxable income comes in at just $115,000—well below their QBI.

Under Section 199A rules, the QBI deduction is the lesser of:

·         20% of QBI → 20% × $138,525 = $27,705

·         20% of taxable income → 20% × $115,000 = $23,000

Because taxable income is lower than QBI, the deduction is capped at $23,000, not the full $27,705. That’s a loss of $4,705 in deductible income—translating to roughly $1,400 in missed tax savings at a 30% tax rate.

Now let’s say this client executes a Roth conversion of $23,525 which is just enough to raise their taxable income of $115,000 to match their QBI of $138,525. While the conversion is taxable, the additional income does two important things:

·         It increases taxable income enough to unlock the full $27,705 QBI deduction.

·         It moves money into a Roth IRA, where future growth is completely tax-free.

Because the additional Roth income is partially offset by the increased QBI deduction, the client ends up only paying taxes on about 80% of that conversion, making the effective tax cost lower than expected.

This is a great example of how one strategic move, when carefully planned for the right client, can create two distinct tax benefits.

Why Paying Taxes Now Could Save You More Later

A common question we hear from clients when introducing this strategy is:

“Why would I voluntarily pay taxes now when I can defer them into the future?”

It’s a fair question and for some, the answer is “you shouldn’t.” But for others, converting pre-tax money to a Roth account makes a lot of sense, especially because we’re living in one of the lowest tax rate environments in US history (yes, really!).

Our goal is always to reduce your lifetime taxes paid, even if that means paying slightly more in the current year. And if tax rates rise in the future (as many expect), paying taxes now could mean locking in a lower rate on those dollars for good. Especially if you’re eligible for the QBI deduction, as a well-timed Roth conversion can effectively mean generating an additional 20% QBI deduction thus only paying tax on 80% of your conversion amount. It's one of the rare windows where paying taxes now may actually be the smart, long-term move.

Proactive Planning Is Key to Maximizing Your QBI Benefit

Just as the QBI deduction hasn’t always existed, it’s not guaranteed to be around, or the same, moving forward. Legislation is constantly changing and having a pulse on proposed updates is crucial to making informed decisions. The proposed “One Big Beautiful Bill” (BBB) currently making its way through congress contains several provisions we’ll be watching closely, including: permanency, increased deduction to 23%, modified taxable income limitations, inflation adjustments, and more. We’ll be keeping a close eye on any update as this may change the strategies we choose to implement for our clients.

There are many other strategies that can be used to optimize QBI and taxable income, and plenty of nuance in the rules. That’s why year-round, proactive planning is essential. Once January 1st arrives, many tax-saving moves—like Roth conversions—are off the table.

Make sure you’re working with a planner who understands how your business income, tax strategy, and retirement accounts all fit together.

Take the Next Step

This is one small example of how 24Acres applies expertise and proactiveness to make sure our clients are making the best decisions available to them. 

If you’d like a no-cost, no-obligation consultation on your financial plan and tax strategy, contact us.  

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