A 401(k) plan is a common benefit offered by many large companies. Small companies may shy away from offering such a plan under the common misconception that this benefit is complicated, risky, or too expensive. If you are reluctant to add this benefit, keep reading to see how the benefits of setting up a 401(k) for your small business stack up – and may outweigh the cost!
Should a small business offer a 401(k)?
There are several advantages to offering a 401(k) that may change your perspective. By offering a 401(k), a small business owner can:
- Stay competitive by attracting and keeping top talent. We can all agree that finding quality staff is a huge challenge. Many applicants expect to see a 401(k) or other retirement plan as part of their benefits package. Recruiting, hiring, and employee turnover costs could all be reduced by taking care of your team with great benefits. Do not underestimate the perk of helping low-paid employees save for retirement as well.
- Accumulate tax savings at the business level. A company match is tax deductible to the business, creating an additional benefit to your employees while lowering tax obligations. This credit is available for the first three years of implementing a 401(k).
- Create benefits at the personal level. You, as the business owner and/or founder, are more likely to take a salary each year with the ability to make a pre-tax contribution to your own retirement plan. Many entrepreneurs leave a significant amount of their net worth in the business, which can be a gamble. You can reduce the overall risk by adding a retirement plan to your portfolio. The match amount paid into the 401(k) by the company is not included in taxable income at the time of contribution.
How does a 401(k) work within a small business?
For illustrative purposes, let us look at an example of implementing a safe harbor 401(k) plan for a small agency with $3 million in revenue. Let’s assume the two owners are paid $150,000 and $100,000. The three employees are paid $25,000, $50,0000 and $65,000. They have elected an employer contribution of 3% with both owners contributing 10% of their wages.
% of Ownership
Gross Earnings
Employee Contribution
Employer Match
Owner #1
50
150,000
15,000
4,500
Owner #2
50
100,000
10,000
3,000
Totals
250,000
25,000
7,500
Employee #1
0
25,000
750
750
Employee #2
0
50,000
1,500
1,500
Employee #3
0
65,000
1,950
1,950
Totals
140,000
4,200
4,200
Grand Totals
100
390,000
29,200
11,700
Using this chart, we can estimate the small business owner’s tax savings using an effective total income tax rate of 30% as follows:
Salary Deferral Amounts
25,000
30%
7,500
Company Match @ 3%
11,700
30%
3,510
Projected tax savings:
11,700
The tax savings for Owner #1 is $ 6,255.
The tax savings for Owner #2 is $ 4,755.
This plan also shows a projected total of pre-tax contributions to their personal retirement plan of:
-
- Owner #1 = $19,500
- Owner #2 = $13,000
In this example, implementing a safe harbor 401(k) plan allows the small business owners to contribute $32,500 in pretax dollars to their personal portfolio, and save $11,010 in tax, while providing a valuable retirement benefit to all the employees of their company. This example also illustrates how it only costs an additional $4,200 in contributions on behalf of their employees to receive an overall tax savings of $11,010.
What 401(k) plans are available?
Here are the types of 401(k) plans to consider:
Type
Requirements
Employee Contribution Limit (2022)
Do Employers Need to Contribute?
Traditional 401(k) Plan
None
Employees under 50: $20,500
Additional $7,500 catch-up if 50+
No
Safe Harbor 401(k) Plan
None
Employees under 50: $20,500
Additional $7,500 catch-up if 50+
Yes
SIMPLE 401(k)
Must have 100 or fewer employees
Employees under 50: $14,000
Additional $3,000 catch-up if 50+
Yes
Solo 401(k)
Must have no employees (except for a spouse or partners)
Employees under 50: $20,500
Additional $7,000 catch-up if 50+
No
Roth 401(k)
None
Employees under 50: $20,500
Additional $7,500 catch-up if 50+
No
Additional considerations
The IRS mandates annual nondiscrimination testing to confirm that highly compensated employees (HCE) do not disproportionately benefit from the plan over other employees, and that IRS contribution limitations are not exceeded during the plan year. This “top-heavy” testing can easily be failed by a small business. Imagine you have a 401(k) plan with 3 participants, including you as the business owner. The business owner (and family members employed) become the key employees most likely holding 60% or more of the plan assets. This is considered top heavy and must be remedied. The safe harbor plan eliminates the need to do top-heavy testing as the plan only receives elective deferrals and safe harbor minimum contributions. The key differential with the safe harbor plan is that employers must make contributions that generally vest immediately while other plans can elect a waiting period before the employees take ownership of the contributions made by the employer.
As a small business owner that has previously passed on offering a 401(k) plan, you may based on these potential benefits for you and your employees. Although the current tax savings are advantageous, it is important to remember that contributions are only tax-deferred, as tax will be paid on the money as it is withdrawn.
If you have any questions about starting a 401(k) for your small business, please feel free to contact us!