401k plans help individuals save for retirement, but businesses can also benefit from setting up a 401k plan. Business owners, just like other employees, have the opportunity to save money for retirement. What’s more, the business itself may also be able to get deductions and tax credits, which provide additional savings to business owners.
If you’re thinking of starting a 401k plan, it’s critical to understand how the plan can reduce taxes for:
- The individuals in the plan (you and your employees)
- The business itself, and business owners
Get familiar with what these plans can—and can’t—do for you.
Retirement Savings for Owners and Employees
Eligible employees can save money for retirement, and they may get tax benefits while doing so. Employees typically have two ways to save, depending on what options you, as the employer, decide to offer.
Pre-tax contributions: Wage-earners can reduce their taxable income by making pre-tax contributions to the 401k. Of course, doing so only postpones the taxes due, as the money is generally taxable when distributions come out of a retirement account. Still, it may make sense to pay taxes later if you believe that your current tax rate is higher than it will be later, when those distributions eventually happen.
After-tax (Roth) contributions: In some plans, employees also have the option to make Roth-type 401k contributions. Those contributions don’t bring any immediate tax relief, but if everything goes according to plan (and if you follow all IRS rules), you might be able to take money out tax-free in retirement. That includes both your own contributions as well as any growth in the account.
More options for owners? Business owners are typically employees themselves. If that’s true for you, you’d have the opportunity to use pre-tax and Roth options as well. In fact, high-income business owners might actually gain additional ways to save by starting a 401k. For example, if you’ve been unable to make Roth IRA contributions or take deductions for traditional IRA contributions due to having a high income, those problems can be eliminated when you establish a 401k.
Significant savings: For 2023, employees can save up to $22,500 per year. That’s the total deferral per employee per year, but it can be split among pre-tax and Roth contributions up to that limit. That’s significantly more than an IRA allows. Those over age 50 can contribute an additional $7,500. Plus, any employer matching or profit-sharing contributions can go in above and beyond those maximums.
Business Tax Savings
Whether you’re a sole-proprietorship, another type of pass-through entity, or any other taxable organization, setting up a 401k plan may help you reduce taxes. 401k plans can even be beneficial for nonprofits and their employees.
Employee benefit costs: A 401k and profit sharing plan is an employee benefit. As a result, the expenses you pay for the plan may be deductible. That includes contributions that you make to employees, as well as any administrative costs that come with running the 401k plan. You might pay a third party administrator (TPA), recordkeeper, auditor, or other consultants to help with your plan—and those costs can potentially be written off.
“Cheaper” compensation: Running a 401(k) might help employers keep compensation costs low while still helping employees. Matching and profit-sharing dollars that go into a retirement plan may not trigger the same payroll taxes on wages that go directly to employees. Unemployment insurance premiums could be lower, and other expenses may also be affected. It’s easy to look at the “cost” of a 401(k) plan without considering some of the less obvious benefits.
Potential tax credits:
For 2020 and beyond, employers may qualify for a credit of at least $500. Larger credits may be available, with employers potentially able to take the lesser of:
- $250 for each non-highly-compensated employees (NHCE) eligible to participate
For 2019 and before: Your business may be eligible for a tax credit, up to $500 per year, for up to three years. That’s potentially $1,500 of reduced tax liability.
To learn more, ask your CPA or the IRS about the Credit for Small Employer Pension Plan Startup Costs. That credit is available to businesses with 100 or fewer employees, and which meet other IRS criteria.
Who Wants Lower Profits?
A 401k plan may sound expensive, but it doesn’t have to be. When things work out well, the benefits offset most or all of the costs you pay, and you gain other advantages by offering a plan to employees. To find out if that’s the case for you, ask for an analysis that details costs, required contributions, and more.
Additional benefits for employers: Even if the numbers don’t work out perfectly, it may still make sense to start a 401k for your business.
- You build assets: If you’re not already saving significant amounts for retirement, a 401k plan can help you get started. You can change from saving zero (or very little) per year, to making progress toward retirement goals. If you’re relying on selling your business at retirement, your 401k savings can give you breathing room to find the right transition plan at the right price. And sometimes life happens quickly—you may be forced to make changes due to health reasons (whether it’s your own health or a loved one that needs help), or you may just want to call it quits and walk away.
- Competitive employee benefit: Your employees may also appreciate if you set up a 401k plan. Some of them aren’t saving for retirement at all. For others, low IRA maximums and high incomes prevent them from saving enough. Give your staff one more reason to love your company.
- Profit sharing: Again, you may be able to accumulate savings above and beyond the annual salary deferral limit. If your retirement plan includes a profit-sharing component (most do) or the ability to match, you can save even more.
- Reward key employees: Advanced plan designs allow you to focus where your profit-sharing contributions go. You can often direct most of the contribution to yourself or key employees while minimizing costs for high-turnover employee groups (using IRS-sanctioned rules to limit vested balances). This is completely legal, and it makes sense to reward those who bring the most value to your business.
Hopefully this page gives you the information you need to start the conversation about starting a 401k. Now dig deeper by asking your CPA how these concepts apply to your specific situation. Only a qualified tax preparer (I’m not one of those) can tell you how your returns might be affected and which credits might be available to your business. Also, familiarize yourself with other aspects of running a plan, including your fiduciary liability, discrimination testing and safe-harbor rules, and Department of Labor regulations.