A 401(k) plan offers a number of benefits for your employees participating in the plan and for you as the employer offering the plan. High among these benefits are the tax benefits for both employees and for the employer.
Tax benefits for employees
Employee contributions are made on a pre-tax basis. This can provide a significant tax break for many employees, especially under the current tax rules that make it harder for most taxpayers to itemize deductions on their tax returns. There has been speculation that President Biden may change the tax break on 401(k) contributions to a tax credit, we will see how this plays out.
Tax-deferred and tax-free growth
Perhaps the biggest tax advantage from a 401(k) is the tax-deferred or tax-free growth of your employee’s contributions as they invest for retirement. Contributions to a traditional 401(k) grow tax-deferred until withdrawn at retirement, money invested in a designated Roth 401(k) account can grow tax-free until withdrawn, subject to a few rules.
Compound growth is a powerful tool, it’s power is enhanced in a 401(k) when the employee’s investments are allowed to grow without the impact of current year taxes on their account.
Benefits for the business owner
Small business owners are generally employees of the business. A 401(k) plan can offer business owners a way to reap the tax benefits from pre-tax contributions as well as the benefits of tax-deferred (or tax-free) growth for their retirement savings. In some cases, the plan design can be done in a way that legally allows them to receive a larger share of any profit-sharing contributions if they are significantly older than most of the company’s employees.
A 401(k) offers the business owner tax breaks not only based on their own contributions, but also from the tax break the company realizes from the portion of any profit-sharing contributions made to the owner’s account.
Tax benefits for employers
Beyond the benefits of being an employee retention tool and helping your employees save for retirement, a 401(k) plan offers several tax benefits for the plan sponsor as well.
Employee matching and profit-sharing contributions
Contributions made to employee’s accounts as matching or profit-sharing contributions are tax-deductible to the employer up to certain annual limits. For 2021 the limits are:
- For employee and employer contributions, the total combined amount contributed cannot exceed $58,000, with $64,500 for those who are 50 or over including their catch-up contributions.
- The employee compensation limit for calculating contributions is $290,000.
There can be a number of expenses involved with establishing a new 401(k), switching providers and the ongoing management and administration of the plan. To the extent these expenses are paid by the employer from company assets, they are deductible as expenses of the business.
The ability to deduct many of the expenses associated with offering a 401(k) can serve to reduce your company’s net cost of offering the plan.
Any of these expenses that are paid out of plan assets would not be tax-deductible as a business expense, however.
As part of the SECURE Act, there is a tax credit available for newly started plans for a three-year period. The credit amount is up to $5,000 per year for eligible start-up costs. There is an additional $500 annual credit available if the plan includes an auto-enrollment feature. This brings the tax credit to a possible total of $16,500 over three years.
Employer’s cannot double-dip here, in other words, the credit is not available for any plan costs that you claim as a deductible business expense.
A 401(k) is widely regarded as a significant employee benefit. In some cases, the quality of an employer’s 401(k) plan has been cited as a factor by employees in deciding whether to join an organization or opt for a position with another employer.
A 401(k) can provide a significant tax benefit for your employees and for you as the plan sponsor. Consult with your plan advisor and your tax professional to ensure that your company is realizing all of the tax benefits associated with sponsoring a 401(k) plan.
Shelton Capital Management does not provide accounting or tax advice to its clients. All clients should be aware that tax treatment is subject to change by law, in the future or retroactively, and clients should consult with their tax advisors regarding any potential strategy, investment or transaction.