A 401(k) is a retirement savings account sponsored by a business that allows employees to save for retirement with pretax dollars. Many large companies offer them as an employee benefit. But 401(k)s can also be beneficial to small businesses and their workers. They allow a business owner to save for their own retirement while helping to attract and retain staff.
Small business owners can set up a traditional 401(k) whether they are the sole employee or have multiple employees. If they are the sole employee, they’ll need to get a Solo 401(k). If they have employees besides themselves, then they must set up a 401(k) just like any other company.
401(k) for small business costs
Small business owners must pay a 401(k) plan administrator to set up and manage a 401(k) plan. This comes with an array of costs:
- Start-up costs: These can vary depending on the provider and plan a business chooses. The business can expect to pay the administrator a one-time fee for the initial costs of setting up the plan and providing information to the employees regarding the plan. The typical range for these services is $500 to $2,000.
- Administrative fees and expense: Small business owners may have to pay fees for recordkeeping, accounting, and customer service provided by the 401(k) plan’s administrator. There may also be expenses associated with optional services such as offering employees loans from the 401(k) plan.
- Optional matching contributions: An employer has the option of offering its employees a 401(k) match. They could match a percentage of an employee’s contributions or do a dollar-for-dollar match, up to a limit.
How to set up a 401(k) for a small business
Mutual fund companies, brokerage firms or insurance companies offer 401(k)s for small businesses. These services help a small business follow the procedures to establish a 401(k) set by the IRS. This process requires the following steps, some of which will be handled by the plan provider:
- Decide on the type of 401(k) to offer. Potential options include the traditional 401(k), safe harbor 401(k), SIMPLE 401(k), or an automatic enrollment 401(k). The provider may give input on which 401(k) is best for the company based on the company’s size and budget. A written plan should cover the type of 401(k) that will be utilized, as well as the policies, such as matching contributions or loans to plan participants.
- Set up a trust and choose a trustee. All of the assets from the 401(k) plan must be held in a trust to ensure that all contributions are maintained for the benefit of the employees and their beneficiaries. The trust must also have a trustee: An individual or entity who holds fiduciary responsibility to ensure the integrity of the 401(k) plan. The trustee can be an individual or entity (e.g., the small business can be its own trustee), but typically an external third party provides the most protection against liability. The administrator of the plan can help determine an appropriate trustee.
- Implement a system for records. It is required by law for employers to keep records of the financial transactions such as contributions, gains and losses in the plan, expenses, among other information. A provider usually takes care of this.
- Inform the employees. The business owner is required by the IRS to send to all potential plan participants information regarding eligibility and benefits for the 401(k) plan.
The benefits of setting up a 401(k) for a small business
401(k)s come with a number of benefits to employees and the business owner. For an employee, a 401(k) plan offers them the ability to save for retirement with pre-tax dollars (taxes only are paid on withdrawals). For a small business owner, the benefits of offering a 401(k) plan include the following:
Attract and retain talent
Offering a retirement plan is a perk that may make a job opening at a small business more appealing to qualified workers who might otherwise gravitate to large companies.
Potential tax credits
Small business owners can potentially claim a tax credit for starting a 401(k) plan. In addition, there is a potential tax credit if the employer offers workers automatic enrollment in the plan. The credit may be worth as much as $5,000 for eligible employers. A small business owner may be eligible to claim a credit if they:
- Employ 100 or fewer employees who earned at least $5,000 from the same company in the previous year.
- Had at least one employee participate in the 401(k) who was a non-highly compensated employee as defined by the IRS.
- Had employees who were not participants in another retirement plan offered by the same company in the previous three years.
Potential tax deductions
In addition to a tax credit there is also a potential for a tax deduction for businesses that offer a 401(k) plan. This can reduce the small business’ taxable income. First, potential deductions can be taken for ordinary business expenses. If an employer pays the administrative fees for the 401(k) plan, this may qualify as a business expense. Another potential deduction is if the employer offers a matching contribution. Matching contributions, up to a certain extent, may be considered an ordinary business expense. The IRS sets out the deduction limits that are allowable for businesses offering a 401(k) plan.
Allowing the small business owner to save for retirement
Not only does offering a 401(k) benefit employees and the business, but it can also be a benefit to the small business owner as a tool to save for their own retirement. Saving in a 401(k) may also provide personal tax savings by lowering the business owner’s taxable income.
Alternatives to a 401(k) for small businesses
Small business owners have options beyond a 401(k) to save for their own retirement, including individual retirement accounts (IRAs). An IRA allows individuals to save for retirement with pretax dollars in an account that isn’t sponsored by an employer. The differences between a traditional 401(k) and an IRA include who can contribute to the account, contribution limits, and taxes, depending on the type of IRA.
There are also IRA plans available to small businesses, which cover both the business owner and their employees.
A Simplified Employee Pension, or SEP IRA, is an option open to both the solo business owner and a business with employees, but it can usually only be funded with contributions from the employer. Typically, but depending on plan rules, employees cannot contribute to a SEP IRA.
The employer must make the same percentage-of-salary contribution to an employee’s account that they make to their own account. For example, if a small business owner contributes 10% of their pay to their account, they must contribute 10% of an employee’s salary to every eligible employee’s account.
A Simplified Incentive Match Plan for Employees, or SIMPLE IRA, is available to small businesses with fewer than 100 employees. Small business owners are required to contribute to each employee’s SIMPLE IRA account each year if an employee elects to contribute. The business owner must make a matching contribution up to 3% of the employee’s salary, or if the employee does not elect to contribute to the account, the business owner must contribute 2% of the employee’s salary.
The bottom line
A 401(k) is a tax-advantaged retirement account that a business can implement at the workplace. A 401(k) can help a small employer attract and retain workers, while potential tax credits and deductions can defray some of the costs of setting up such a plan. These savings plans can help these companies compete for talent with larger corporations, many of which offer their employees 401(k) plans. With the right knowledge and planning, a small business can also offer this as a perk to its employees.