Federal tax deduction and tax credits can help offset the cost of starting a retirement plan for your employees.
Here's what you need to know:
- The federal government is incentivizing helping employees save for retirement
- Small business owners benefit by contributing to a 401(k) program as an employee
- 401(k) employer contributions are deductible
To encourage more companies to offer 401(k) plans, the government provides tax credits and deductions that can really add up. And the deal recently got even sweeter for companies with fewer than 100 employees, thanks to legislation that increased the available tax credits. Be sure you understand and take full advantage of all the tax benefits available to you, thereby lowering the overall costs of providing a valuable retirement savings plan to your employees.
401(k) plan costs
There’s no question that a 401(k) plan can provide a valuable benefit to employees, giving them the opportunity to save significant dollars for their retirement, regardless of how far into the future that may be. In addition, a 401(k) can bring significant benefits to employers in that it can help attract and retain talent. In fact, research shows that it’s an important consideration for individuals evaluating new job opportunities.
Yet even those employers who understand these benefits may be on the fence about offering a 401(k) plan because of concerns about costs. But the expenses may be less than feared: certain costs are typically passed onto the employees, and many expenses that do fall on the employer may be eligible for tax deductions and credits, including some that were recently introduced and others that were recently increased. After all, the government wants to encourage companies to provide retirement savings programs for their employees. These tax deductions and credits can really add up, and they’re even greater today than they’ve ever been. Let’s look at each area of opportunity that could lower your taxes.
Available tax credits
Tax credits can be even more valuable than tax deductions, since they reduce the amount of taxes owed on a dollar-for-dollar basis.
Tax credits can be even more valuable than tax deductions, since they reduce the amount of taxes owed on a dollar-for-dollar basis. Companies with fewer than 100 employees may be eligible for up to $16,500 over 3 years, thanks to the passage of the SECURE (Setting Every Community Up for Retirement) Act in late 2019.
Tax credits can help offset 401(k) startup costs
For many years now, businesses with fewer than 100 employees have been eligible to receive a tax credit for expenses associated with starting up a 401(k) plan. But the SECURE Act increased the maximum available credit significantly: from just $500 per year for the first 3 years of a plan’s existence to $5,000 per year for the first 3 years or a total of $15,000.
Specifically, an employer can receive a credit for 50% of the cost to establish and administer a 401(k) plan, up to the greater of $500 OR the lesser of:
1. $250 per plan-eligible non-highly compensated employee, and
Automatically enrolling employees into the plan? There’s a tax credit for that!
For years, companies that offered 401(k) plans did so on an opt-in basis. Vanguard’s How America Saves report finds that plan participation rate for these voluntary contribution plans hovers around 60%. But as the government woke up to the reality of having too many retirees with too little retirement income, it promoted 401(k) automatic enrollment, whereby an employee must actively opt out of the plan. Automatic enrollment plans have become quite popular as employees have been shown to embrace them, with low opt-out rates. In fact, Vanguard reports a 92% automatic enrollment plan participation rate, meaning more Americans are saving through employer-sponsored retirement plans today.
The most recent example of the government’s support for automatic enrollment is the SECURE Act provision that gives employers whose plans have that feature an annual tax credit of up to $500/year for 3 years, for a total of $1,500. Remember, this credit is only for companies with fewer than 100 employees. However, it is available not just to brand new plans but also to existing plans that decide to add the automatic enrollment feature.
401(k) admin fees you pay are tax-deductible
If your company has more than 100 employees and doesn’t qualify for tax credits, you may be able to reduce taxable income by deducting 401(k) administrative fees as business expenses. (If your company does have fewer than 100 employees, you should probably take the credit, which is more valuable. You can’t do both!)
Administration fees paid by the company often include recordkeeping, legal, and audit fees. In addition to reducing the company’s taxable income, having the company pay for these items means reducing the costs absorbed by employees which would otherwise detract from investment returns. When expenses like these are charged to the plan, they are usually allocated on an asset basis, meaning the largest account balances pay the highest dollar amount. Therefore, participants with the largest accounts, often the owner(s) of the company, could benefit significantly from having the company pay these costs.
Yes, you can deduct 401(k) employer contributions
Employer contributions to employee 401(k) accounts represent a win/win for employees and employers: not only do employer contributions enhance the value of the plan benefit for employees, making it easier for them to reach their retirement goals sooner, but employer contributions are tax deductible to the company. Plus, they may make it easier for owners and other highly compensated employees to increase their own contributions to the plan because of mechanics related to 401(k) compliance testing.
Just how much can companies contribute (and therefore deduct) for employer contributions? The limit is 25% of compensation paid, to a maximum of $285,000 ($290,000 in 2021). In addition, combined employer and employee contributions are limited to the lessor of:
- $57,000 ($58,000 in 2021) or $63,500 ($64,500) for those 50+ OR
- 100% of the employee’s annual compensation
Self-employed individuals must make a special computation to figure their maximum deduction for their contributions.
If your company decides to enhance its 401(k) benefit with an employer contribution, the pros and cons of each form should be carefully evaluated to determine which is most appropriate for your organization.
- Matching — expressed as a formula (for instance 50% on the first 6% of an employee’s contribution), matching contributions are conditional on employee contributions and therefore often encourage employees to put more of their own money into plan
- Profit sharing — also called nonelective contributions, these are not conditional on employee contributions and can be allocated using various methods allowed by the IRS
The employer contribution provision will be incorporated into the plan document. Companies who are not sure they can commit to a contribution each year often make the contribution on a discretionary basis, providing flexibility to determine the amount each year (or even whether to make a contribution at all).
By design, safe harbor 401(k) plans require the employer to make either matching or nonelective contributions. As such, these employer contributions cannot be discretionary.
Business owners benefit by contributing to the plan as an employee
In addition to making contributions to the 401(k) as an employer, a business owner can also make contributions to the 401(k) plan as an employee. Annual 401(k) employee contributions (for 2020 and 2021) are limited to $19,500 (or $26,000 for individuals 50+). And the combined employee + employer contributions are limited as noted earlier.
Because they are made with earned income, taxes on 401(k) contributions are inevitable, but they can be deferred. In fact, by choosing between traditional and Roth contributions, you can control when you pay any taxes owed:
- Traditional 401(k) contributions are made on a pre-tax basis, reducing your taxable income. You will owe taxes in the future, when you withdraw contributions and their earnings.
- Roth 401(k) contributions are made on an after-tax basis. Even though they don’t reduce your current taxable income, they enable you to make tax-free withdrawals (of contributions and earnings) in the future.
Generally speaking, if you think you are in a lower tax bracket today than you will be at retirement, Roth contributions might make sense. If the reverse is true, traditional 401(k) contributions may be the way to go. Many plans allow you to contribute to both account types so that you can hedge your bets a bit. Either way, contributing to a 401(k) plan is a great, tax-smart way to put money away for your future.
Generally speaking, if you think you are in a lower tax bracket today than you will be at retirement, Roth contributions might make sense. If the reverse is true, traditional 401(k) contributions may be the way to go.
Evaluating whether or not to offer a 401(k) plan?
If you’re thinking about offering a 401(k) plan, be sure to look at the bigger picture and take into consideration the value the plan will bring to you and to your organization. In addition, don’t overlook the available and not insignificant tax benefits that may help offset the costs.
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