The situation: A sixty-five-year-old client nearing retirement owns an S-corporation, is eligible for the qualified business income deduction and is nearing the phaseout range. Most of her retirement assets are in traditional retirement accounts, which are fully taxed when disbursed. Should she contribute to a Roth this year or reduce income and taxes by maximizing contributions to the traditional retirement account?
Background and Analysis
The qualified business income deduction generally allows eligible business owners to deduct up to 20 percent of qualifying business income. An S corporation owner’s qualifying pass-through profits may receive the deduction; her employee salary does not. Eligibility also depends on household taxable income and the type of business.
Salary, distributions, and retirement contributions
An S corporation owner can adjust her salary, but she must receive reasonable compensation for her services before taking nonwage distributions.
Retirement contributions for an S corporation shareholder-employee are based on eligible W-2 compensation. For a 65-year-old participating in a standard 401(k) in 2026:
Regular employee contributions: Up to $24,500, divided between traditional and Roth contributions as she chooses, provided the plan offers both. Traditional contributions reduce current taxable income; Roth contributions do not.
Catch-up contributions: An additional $8,000. If her 2025 Social Security wages from the sponsoring employer exceeded $150,000, this contribution must be Roth. Otherwise, it can generally be traditional or Roth, subject to the plan’s options.
Employer contributions: In a straightforward owner-only plan, generally up to 25 percent of eligible compensation, subject to the plan’s terms. These ordinarily go into a traditional account. A plan may offer Roth employer contributions, which are included in the employee’s current income.
Combined limit: Regular employee and employer contributions together cannot exceed $72,000. Including the $8,000 catch-up, the total can reach $80,000. Choosing Roth does not increase these limits.
Other employees: Coverage and nondiscrimination rules can require contributions for other eligible employees.
For example, $190,000 of eligible compensation could support a $47,500 employer contribution plus a $24,500 regular employee contribution, reaching $72,000. The $8,000 catch-up would bring the total to $80,000, although its required tax treatment depends on her prior-year wages.
A traditional employee contribution reduces household taxable income and can therefore help the owner avoid or reduce the QBI deduction’s phaseout. Holding compensation and employer contributions constant, it does so without reducing the corporation’s QBI.
A Roth employee contribution does not reduce household taxable income and therefore does not help the owner avoid the phaseout.
Choosing Roth instead of traditional can increase current taxes in two ways: she forgoes the deduction for the retirement contribution and may lose part of her QBI deduction.
If the catch-up contribution must be Roth, she cannot use that additional $8,000 to lower household taxable income. Under IRS rules, this requirement applies in 2026 if her 2025 wages subject to Social Security tax from the employer sponsoring her plan exceeded $150,000.
A traditional retirement contribution paid by her S corporation reduces the business profit reported on her household tax return. This lowers household taxable income and may help preserve a QBI deduction that would otherwise be phased out. However, the contribution also reduces the business income eligible for that deduction. The tax calculation must account for both effects.
Salary, employer contributions, and the employee’s traditional-versus-Roth election should therefore be evaluated together.
How the QBI Phaseout Affects the Contribution Decision
For married couples filing jointly in 2026, restrictions depend on total household taxable income before the QBI deduction:
At or below $403,500: The income-based restrictions do not apply.
Between $403,500 and $553,500: The deduction for a specified service business, including a legal or medical practice, is gradually eliminated.
At or above $553,500: No deduction is available for that service business. Other qualifying businesses may retain a deduction, subject to employee-wage and qualifying-property limits.
The interval from $403,500 to $553,500 is called the phaseout range. Its $150,000 width is fixed for joint filers in 2026.
Consider a couple filing jointly with $200,000 in qualified business income and household taxable income before the QBI deduction of $403,500. Their full QBI deduction is $40,000—20% of qualified business income. If their business is a specified service business, that deduction phases out as household income before the deduction rises through the 2026 range of $403,500 to $553,500. At $478,500, halfway through the phaseout range, the deduction is $20,000. At $553,500,the deduction is zero.
Within this interval, each additional $1,000 of non-QBI income eliminates approximately $267 of the deduction. Taxable income after the deduction therefore rises by approximately $1,267. The effective marginal federal income tax rate becomes:
30.4 percent when the additional taxable income falls in the 24 percent statutory bracket.
Approximately 40.5 percent when it falls in the 32 percent statutory bracket.
At higher income within the same phaseout range, the couple could enter the 35 percent statutory bracket, raising the effective marginal federal rate to approximately 44.3 percent. These rates exclude state income taxes.
A traditional employee 401(k) contribution reduces taxable wages and can preserve part of the QBI deduction without reducing the corporation’s QBI. A Roth employee contribution provides neither current tax benefit.
At higher income within the phaseout range, the effective federal marginal rate reaches approximately 40.5 percent in the 32 percent bracket; adding California’s 9.3 percent marginal rate brings the combined rate to approximately 49.8 percent before other tax interactions.
Retirement wealth, required distributions, and taxes
Having more Roth assets provides greater control over taxable retirement income. Qualified Roth withdrawals are tax-free, and Roth accounts have no required minimum distributions during the owner’s lifetime. Traditional accounts generally require taxable distributions; under the Uniform Lifetime Table, the age-75 distribution is approximately 4.07 percent of the preceding year-end balance.
Consider a married couple, both age 75, receiving $40,000 of fully taxable pension income and $60,000 of Social Security benefits. Assume all traditional balances are pretax and withdrawals are limited to RMDs:
$1 million, 10 percent Roth: $100,000 in Roth and $900,000 in traditional accounts. Annual RMD: $36,585. Approximate federal income tax: $10,554.
$1 million, 40 percent Roth: $400,000 in Roth and $600,000 in traditional accounts. Annual RMD: $24,390. Approximate federal income tax: $9,091.
$4 million, 10 percent Roth: $400,000 in Roth and $3.6 million in traditional accounts. Annual RMD: $146,341. Approximate federal income tax: $33,829.
$4 million, 40 percent Roth: $1.6 million in Roth and $2.4 million in traditional accounts. Annual RMD: $97,561. Approximate federal income tax: $23,097.
These calculations use 2026 federal tax brackets and a $35,500 standard deduction for a married couple both over 65, excluding the temporary additional senior deduction. They exclude investment income, state taxes, credits, and additional withdrawals. They illustrate differences under a fixed tax schedule rather than predict tax bills ten years from now.
In all four examples, 85 percent of Social Security benefits—$51,000—is included in taxable income. A larger Roth share therefore does not reduce Social Security inclusion here, although it could for a household with less other income.
Medicare premiums create an additional difference:
$4 million, 10 percent Roth: Modified adjusted gross income is approximately $237,341, above the 2026 joint surcharge threshold of $218,000. If this income applied in the relevant lookback year, the first surcharge tier would add approximately $2,297 annually for two spouses enrolled in both Part B and Part D.
In the other three examples income remains below that threshold, so no income-related surcharge would apply under the same assumptions.
Medicare generally uses income from two years earlier. Actual taxes and premiums will vary with age, market performance, spending, other income, and future law. A surviving spouse may face higher costs because single-filer thresholds are lower.
These examples show the flexibility provided by Roth assets accumulated over a lifetime. They do not establish that Roth contributions are preferable in every working year.
A more comparison would also count additional retirement savings financed by the tax deductions received from traditional contributions.
Factors That Should Determine the Decision
A person whose wealth is concentrated in traditional retirement accounts can face substantial future taxes and Medicare surcharges. But the traditional/Roth mix reflects a lifetime of contributions, investment returns, and withdrawals. One contribution at age 65 cannot substantially change that history.
This client faces a high current marginal tax rate, potentially increased by the loss of her QBI deduction. This is probably an expensive year to begin correcting her shortage of Roth assets.
In this particular year for this client, I would favor traditional contributions where permitted, subject to the final tax calculation, invest the tax savings, and look for less expensive opportunities to convert assets to Roth after retirement.
The years after wages and business profits end, but before required distributions begin, may offer a less expensive opportunity to convert traditional assets to Roth. Liquid savings outside retirement accounts can cover living expenses and conversion taxes. Delaying Social Security may expand this opportunity if the household can finance the delay.
See “Converting Traditional Retirement Assets to Roth Assets in Retirement.”
Downsizing may release home equity and reduce housing expenses, allowing the client to finance spending and conversion taxes with fewer taxable retirement withdrawals. The benefit depends on replacement housing costs, moving expenses, the home sale’s tax treatment, and her preferences.
Selling the business could provide liquid assets to support retirement and conversions but taxes will be elevated in the year of the sale.
Concluding thought:
Younger workers should seek opportunities to build Roth savings, particularly in lower-tax years. I recognize that this can be difficult. Student debt and health-insurance premiums tied to income can make traditional contributions especially attractive: reducing adjusted gross income can lower loan payments and premiums as well as taxes.
These incentives can leave households short of Roth assets later as discussed in “Liquidity Today, Tax Traps Tomorrow.”
The lesson for younger workers is to consider the lifetime value of Roth savings alongside the immediate benefits of reducing taxable income.
Authors Note: The editor of this multifaceted blog on economic policy, finance, and politics is a retired economist who spent most of his career with the U.S. Treasury. Most of the material published here is free, but a paid subscription only costs $30 with this coupon.