Small business owners can boost employee recruitment and retention and help themselves and their workers save for retirement by establishing a 401(k) plan. These plans can only be set up by employers, and offer valuable tax benefits including tax-free growth of investments and, depending on the type of plan, tax-deductible contributions or tax-free withdrawals.
A financial advisor can help you evaluate retirement savings options for you and your employees.
401(k) Basics
A 401(k) is a retirement savings plan that provides tax advantages. Only employers can set up 401(k) plans but both employers and employees can contribute. Plans are funded with money participants voluntarily defer from their earnings. Employers can, at their option, match employee contributions. Employers can also save for their own retirements through company-sponsored 401(k) plans.
Contributions to most types of 401(k) plans are made pre-tax. That is, federal income taxes are not withheld or required to be paid. Employees and employers can deduct these contributions form current income. When contributions and earnings are withdrawn, they will be taxed as current income. Withdrawals before age 59.5, in most cases, will owe an additional penalty.
Roth 401(k) plans are funded with after-tax contributions. These contributions are not deductible but can be withdrawn at any time without penalty or tax. Earnings on accounts that are part of Roth 401(k) plans can be withdrawn after age 59.5 without owing penalties or taxes, as long as the account has been set up for at least five years.
There are also limits on annual 401(k) contributions. These adjust annually. For 2023, employees can contribute a maximum of $22,500. Employees over 50 can contribute an extra 7,500 for 2023. There are also limits on how much employers can contribute through matching. For 2023, the employer contribution limit is $40,500.
In order to make sure plans are fair, most 401(k) plans are subject to nondiscrimination testing. These tests ensure that owns and managers don’t receive benefits that are excessive compared to those available to rank-and-file employees.
Funds in any type of 401(k) plan can be invested to grow the size of the account. Investments may include mutual funds, exchange-traded funds, savings accounts, money market funds and other types.
401(k) Benefits
Employees are drawn to 401(k) plans and not all employers offer them. As a result, having a 401(k) can be a way to attract and keep talented workers. Offering a generous match, for instance, can be seen as giving employees free money for retirement.
Specific plan features can be designed to encourage employees to continue working for a company. For example, employers can within boundaries determine vesting rules, which decide how quickly employer-matching contributions become the property of the employees. Employees may be motivated to stay until employer matches are vested.
When employers use 401(k) plans to save for their own retirement, they get the same benefits as employees, including the deferred tax on regular 401(k) contributions and tax-free withdrawals on Roth 401(k) withdrawals. Employer contributions to the plan also are deductible on the business’s tax return. However, employers have many legal requirements to meet, including obligations to meet non-discrimination standards.
Other 401(k) Plan Types
In addition to Roth 401(k) plans and traditional 401(k) plans, there are some other options for employers to consider. These include SIMPLE 401(k) plans and safe harbor 401(k) plans.
Safe Harbor 401(k)
Safe Harbor 401(k) plans have fewer nondiscrimination requirements than other plans. Employers have to match employer contributions to these plans, and employer contributions must vest immediately.
SIMPLE 401(k)
SIMPLE 401(k) plans are intended for businesses with fewer than 100 employees. Employer contributions are mandatory.
Solo 401(k)
Solo 401(k) plans are for individual self-employed people and sole proprietors who have no employees other than their spouses. Business owners can make contributions as employees and as employers.
Setting up A Small Business 401(k)
Business owners who decide to offer 401(k) plans face a process involving a number of steps. They include:
- Decide whether to set up the plan yourself or get professional assistance from a financial advisor or financial institution that offers plans.
- Select the type of plan that will be offered.
- Adopt a written document that describes the plan.
- Set up a trust for the plan’s assets.
- Create a recordkeeping system to track contributions, vesting, investments, withdrawals and account balances and other information.
- Provide eligible employees with information about the plan.
- Make any required employer-matching contributions.
- Report to government agencies that oversee plans.
- Distribute benefits to participants.
Bottom Line
A 401(k) plan allows a small business owner and their employees to defer earnings for retirement while providing tax benefits to employees, employer and the business. There are several 401(k) plan types, including ones for businesses with fewer than 100 employees and self-employed individuals. Traditional 401(k) plans are funded with pre-tax contributions, while Roth 401(k) plans are funded with after-tax salary deferrals.
Financial Planning Tips
- Consider talking to a financial advisor about your business’s options for setting up retirement savings plans. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- SmartAsset’s 401k Calculator helps you see how your 401(k) account will grow as time goes by. Using your personal details including your location, income, age, planned retirement date, marital status, expected retirement expenses and projected rate of return, you can find out how well your 401(k) plan will meet your financial needs in retirement.
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