Optimizing Your QBI Deduction

Posted August 19, 2025, By Cole Ferrier

As a financial planner with a background in software engineering, I often see parallels between solving complex technical problems and optimizing a financial plan. In both worlds, a small, seemingly insignificant detail in one line can cause the entire system to produce a flawed result.

The Qualified Business Income (QBI) deduction is a perfect example of this. It's a powerful tax break for small business owners, but its complex phase-out rules, especially for a Specified Service Trade or Business (SSTB), can create a counterintuitive result, leading to a much smaller deduction than you might expect.

The good news is that you can often improve the outcome by strategically adjusting the inputs. In a surprising twist of tax planning, making certain pre-tax contributions can actually increase your final QBI deduction. This article will walk you through the logic, demonstrating how two different strategies can help you optimize your tax situation.

Background: Understanding Which Deductions Affect QBI

Before exploring the complexities of the phase-out range, it's helpful to understand a common misconception about the QBI deduction. Many assume that any action reducing taxable income will automatically lower the QBI deduction. This isn't always the case. For instance, if a taxpayer's taxable income is already significantly higher than their business income (perhaps due to a spouse's W-2 wages), deductions that only lower taxable income—without touching QBI—won't harm the QBI deduction. This distinction is particularly important for married couples. If the W-2 earning spouse has access to a retirement plan, prioritizing their contributions over the business owner's can be a powerful strategy. It allows the couple to increase their overall retirement savings while protecting the business owner's full QBI deduction. The real challenge arises with deductions like SEP-IRA contributions, which reduce both taxable income and QBI, forcing a careful balance between immediate tax savings and preserving the full potential of the QBI deduction.

The Problem: How the QBI Phase-Out Limits Your Deduction

First, let's define the issue. For SSTB owners, the QBI deduction is reduced—or "phased out"—once their taxable income crosses a certain threshold. For a single filer in 2025, this phase-out begins at $197,300 and is fully complete at $247,300. When your income falls within this $50,000 range, your deduction is limited by complex rules involving the W-2 wages paid by your business and unadjusted basis of depreciable property owned by the business. The further your income is into this range, the more the limitation squeezes your deduction.

Let's run the numbers on a few scenarios to see how we can address this.

Scenario 1: The Baseline Calculation (No Action)

This taxpayer's income is well into the phase-out range, causing this anomaly to significantly reduce their deduction. This is our starting point.

• Taxable Income Before QBI Deduction: $230,000

• Qualified Business Income (QBI): $210,000

• W-2 Wages Paid by the Business: $50,000

• Allowable QBI Deduction: $8,650

The Calculation 

1. Phase-out Percentage: The taxpayer's income is $32,700 into the $50,000 phase-out range. ($230,000 - $197,300) / $50,000 = 65.4%

2. Applicable Percentage: This is the portion of QBI and W-2 wages that will be used. 100% - 65.4% = 34.6%

3. Applicable Amounts:

   • Applicable QBI: $210,000 x 34.6% = $72,660

   • Applicable W-2 Wages: $50,000 x 34.6% = $17,300

4. Initial QBI Deduction Component (20% of Applicable QBI): $72,660 x 0.20 = $14,532

5. W-2 Wage Limitation (50% of Applicable W-2 Wages): $17,300 x 0.50 = $8,650

6. Allowable QBI Deduction: The deduction is the lesser of the initial component (Step 4) and the wage limitation (Step 5). Lesser of $14,532 and $8,650 is $8,650.

Strategy 1: Shifting Your Phase-Out Position with a SEP-IRA

For this illustration, we will use a SEP-IRA. A SEP-IRA is a common retirement plan for self-employed individuals, and it has the ability to exclude employees who have not worked for the employer in 3 of the last 5 years. That exclusion allows us to simplify this example as the business has an employee that is receiving wages. It's important to note that a contribution to a SEP-IRA reduces both your taxable income and your Qualified Business Income (QBI), as the contribution is considered attributable to the trade or business.

Scenario 2: Applying the SEP-IRA Contribution

Here, the business owner makes a $20,000 contribution to their SEP-IRA. This lowers both their taxable income and their QBI by $20,000. The power of this move comes from shifting to a much more favorable point in the phase-out calculation, even though QBI is also reduced.

• Taxable Income Before QBI Deduction: $210,000 ($230k - $20k)

• Qualified Business Income (QBI): $190,000 ($210k - $20k)

• W-2 Wages Paid by the Business: $50,000

• Allowable QBI Deduction: $18,650

By making a $20,000 retirement contribution, the taxpayer more than doubled their QBI deduction.

The Calculation 

1. Phase-out Percentage: The taxpayer's income is now only $12,700 into the phase-out range. ($210,000 - $197,300) / $50,000 = 25.4%

2. Applicable Percentage: A lower taxable income results in a higher applicable percentage. 100% - 25.4% = 74.6%

3. Applicable Amounts:

   • Applicable QBI: $190,000 x 74.6% = $141,740

   • Applicable W-2 Wages: $50,000 x 74.6% = $37,300

4. Initial QBI Deduction Component (20% of Applicable QBI): $141,740 x 0.20 = $28,348

5. W-2 Wage Limitation (50% of Applicable W-2 Wages): $37,300 x 0.50 = $18,650

6. Allowable QBI Deduction: The deduction is the lesser of the initial component (Step 4) and the wage limitation (Step 5). Lesser of $28,348 and $18,650 is $18,650.

Strategy 2: The Charitable Contribution "Reset"

The SEP-IRA provided a significant boost, but what if we could be even more precise? This next strategy highlights a crucial difference between deductions. A charitable contribution is an itemized deduction that reduces only your taxable income, allowing for a more targeted adjustment that can completely reset the calculation.

Scenario 3: Pushing Taxable Income to the Threshold

This scenario builds on Scenario 2. After the $20,000 SEP-IRA contribution, the taxpayer's taxable income is $210,000. They now make an additional $12,700 charitable gift. This strategic donation lowers their taxable income to exactly $197,300, placing them right at the beginning of the phase-out range and completely removing the wage limitations.

• Taxable Income Before QBI Deduction: $197,300 ($210k - $12.7k)

• Qualified Business Income (QBI): $190,000 (Unchanged from Scenario 2)

• W-2 Wages Paid by the Business: $50,000 (Unchanged)

• Allowable QBI Deduction: Because taxable income is at or below the threshold, the phase-out limitation is removed. The deduction is simply 20% of the full QBI: $190,000 x 0.20 = $38,000.

In this example, charitable gifts had been used to get the taxable income out of the phase out range. This unlocked the QBI deduction from being phased out.

Be aware that if the charitable gifts had lowered Taxable Income Before QBI Deduction below Qualified Business Income, then the limitation is based on that preliminary taxable income figure and reduces how much of a QBI deduction could have been taken.

Conclusion: Quantifying the Return on Your Contribution

The true power of this strategy is revealed when you look at the total tax savings generated. Let's analyze the net out-of-pocket cost of the contributions, assuming a constant 32% marginal tax rate for simplicity.

• Scenario 1 (Baseline): With no strategic contributions, the taxpayer has a $0 outlay and receives a QBI deduction of $8,650. This is our starting point.

• Scenario 2 (SEP-IRA Contribution): The taxpayer makes a $20,000 retirement contribution. This action increases their QBI deduction to $18,650. The combination of the direct deduction for the contribution and the increased QBI deduction generates $9,600 in total tax savings. This means the net out-of-pocket cost to invest $20,000 for retirement was only $10,400.

• Scenario 3 (SEP-IRA + Charitable Gift): The taxpayer contributes $20,000 to retirement and donates $12,700 to charity, for a total outlay of $32,700. This strategy maximizes their QBI deduction to $38,000. The total tax savings from all deductions skyrockets to $19,856. The final net out-of-pocket cost for both the retirement contribution and the charitable gift is only $12,844.

The results are dramatic. By investing $20,000 for retirement and donating $12,700 to a cause they care about, the taxpayer's final out-of-pocket cost was only $2,444 more than if they had only made the retirement contribution. The tax savings generated by this strategy are so significant that they effectively fund the majority of the charitable gift.

By understanding the system's logic, this taxpayer transformed pre-tax contributions into a powerful tool. They not only saved for retirement and supported a cause they care about but also corrected a counterintuitive tax calculation, generating thousands of dollars in additional tax savings.

A Note on State Taxes

It is important to note that this analysis focuses solely on federal income taxes. If you live in a state with its own income tax, the benefits of these strategies could be even greater. The deductions for retirement and charitable contributions would likely reduce your state taxable income as well, generating additional tax savings and further lowering the net out-of-pocket cost of the contributions.

Planning Considerations for 2026 and Later

The tax landscape is not static. The "One Big Beautiful Bill Act," signed in July 2025, introduces changes that will impact these strategies starting in 2026.

• Wider Phase-Out Ranges: The income range over which the QBI deduction is phased out will expand from $50,000 to $75,000 for single filers (and from $100,000 to $150,000 for joint filers). This means the deduction will be reduced at a slower pace as income rises within this range. Consequently, the strategic benefit of making contributions to lower your income within the range will be less pronounced, simply because less of the deduction is being lost in the first place.

• The "Cliff" Remains Critical: Despite the wider range, the lower income threshold remains a critical "cliff." If your deduction is limited by the W-2 wage component, a strategy that pushes your taxable income just below that threshold (like in Scenario 3) can still yield significant value by completely removing the limitation.

• New Charitable Contribution Floor: The new law introduces a floor for the charitable contribution deduction equal to 0.5% of Adjusted Gross Income (AGI). This means the first portion of your charitable gifts may not be deductible. Our analysis assumes the taxpayer is already itemizing and likely meeting this floor with other donations. For someone making their first and only donation, this new floor would need to be factored into the calculation.

Let's Optimize Your QBI Strategy

Navigating the complexities of the QBI deduction can be a significant challenge. If you're a business owner in a Specified Service Trade or Business, you don't have to figure it out alone. We specialize in building resilient financial plans that account for these nuances, and we will typically work with your tax professional on formulating an ideal plan to ensure your strategy is as tax-efficient as possible. Stop leaving money on the table. If you're ready to see how these strategies could apply to your specific numbers and transform confusion into a confident tax plan, contact us today to get started.

Resources

• IRS Form 8995-A, Qualified Business Income Deduction - https://www.irs.gov/pub/irs-pdf/f8995a.pdf

• Schedule A (IRS Form 8995-A), Specified Service Trades or Businesses - https://www.irs.gov/pub/irs-pdf/f8995aa.pdf

• Instructions for Form 8995-A - https://www.irs.gov/instructions/i8995a

• TD 9847 - Qualified Business Income Deduction - https://www.federalregister.gov/documents/2019/02/08/2019-01025/qualified-business-income-deduction

• 26 USC 199A: Qualified business income - https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section199A&num=0&edition=prelim

• H.R.1 - One Big Beautiful Bill Act - https://www.congress.gov/bill/119th-congress/house-bill/1

• Breaking Down The “One Big Beautiful Bill Act”: Impact of New Laws on Tax Planning - https://www.kitces.com/blog/obbba-one-big-beautiful-bill-act-tax-planning-salt-cap-senior-deduction-qbi-deduction-tax-cut-and-jobs-act-tcja-amt-trump-accounts/