Understanding the Tax Advantages of 401(k) Plans for Small Business Owners
Author: Siân Killingsworth / 28 Apr 2023 / 401(k) Plan Information, Safe Harbor, Small Business 401k
Looking for ways to attract top talent to your small business while also saving for your retirement? You’re in the right place. A popular option for accomplishing both goals is to offer your employees a 401(k) plan. Not only does it incentivize them, it also provides you with tax savings. We’re breaking down how.
Tax Advantages for Small Business Owners
Small business owners who offer their employees a 401(k) plan may be eligible for a few different types of tax deductions.
First, when you open a new plan, you can qualify for up to $5,000 per year for the first three years1. Why? Because the government is very enthusiastic about supporting Americans’ retirement!
Second, if that plan has automatic enrollment, you can qualify for another $500 per year for those same three years1. If you all that all up, it’s a potential $16,500 in tax credits. You can use these credits to cover the cost of plan setup and administration.
Finally, any employer contributions you make to your employees (hint: you’re also considered an employee!) are tax-deductible2 for your business, meaning you can reduce the amount of taxable income reported on your business tax return.
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Both you and your employees can benefit from the tax deferral offered by a traditional small business 401(k) plan. Employee contributions are made on a pre-tax basis, meaning they are deducted from their taxable income for the year. This can lower tax liability and increase take-home pay. Taxes on contributions are not due until the funds are withdrawn from the plan.
401(k) plan funds grow tax-free until they are withdrawn in retirement. This means that any investment gains or dividends earned on the funds are not subject to income tax, which can help the funds in the account to grow more quickly over time.
Types of small business 401(k) plans
Let’s briefly review the various types of 401(k) plans that are available to small businesses. These include:
This is the most common type of 401(k) plan. It allows employees to make pre-tax contributions to the plan, and employers can choose to make matching contributions. The funds in the account grow tax-free until they are withdrawn in retirement.
Safe Harbor 401(k)
Looking for a plan that makes it easier for you to pass the annual nondiscrimination tests required by the IRS? A Safe Harbor provision added to your 401(k) could be right for you. Under this plan, employers are required to make contributions to the plan on behalf of their employees, either in the form of a matching contribution or a non-elective contribution.
New Comparability 401(k)
When you add a new comparability provision to your 401(k), this give you as the business owner and your highly compensated employees the flexibility to receive higher percentages of employer profit-sharing contributions than other eligible staff. It’s a great way to reward high-performing employees.
Sole-Provider 401(k) plan
This is a plan designed for self-employed individuals and small business owners with no employees (other than a spouse working for them). It allows for higher contribution limits than traditional 401(k) plans, and can be a powerful retirement savings tool for those who qualify.
1 Eligible employers may be able to claim a tax credit of up to $5,000, for three years, for ordinary and necessary costs of starting a 401(k) plan. IRS’ qualifying factors are: 100% for those with 50 or fewer employees, 50% for those with 100 – 50 employees who received at least $5,000 in compensation from you in the preceding year, you had at least one participant who was a non-highly compensated employee (NHCE) and in the three tax years before the first year you’re eligible for the credit, your employees were substantially the same employees who received contributions or accrued benefits in another plan sponsored by you, a member of a controlled group that includes you, or a predecessor of either. Those plans with automatic enrollment can claim a tax credit of $500 per year for a 3 year taxable period.
2 This credit will generally be a percentage of the amount contributed by the employer on behalf of employees, up to a per-employee cap of $1,000. This full additional credit is limited to employers with 50 or fewer employees and phased out for employers with between 51 and 100 employees. The applicable percentage is 100 percent in the first and second years, 75 percent in the third year, 50 percent in the fourth year, 25 percent in the fifth year – and no credit for tax years thereafter.