Top Tax Reasons to Start a 401(k)
Starting a 401(k) Today Helps Reduce Tomorrow’s Taxes.
Few small business owners know about all the tax benefits that come with 401(k) plans – from tax credits and deductions to protecting more income from taxes. Here are five ways that 401(k) plans enable you to better manage your savings at tax time:
Less Taxing, More Saving
In 2024, you can contribute up to $23,000 tax-deferred into a 401(k) plan ($30,500 if you are over 50 years of age). Let’s say you are under 50 years of age, own a business with seven employees, and contribute $23,000 into your 401(k). As you can see in the example below, a 401(k) offers the potential for more personal tax savings for the owner in the current calendar year even compared to a traditional IRA.
401(k) vs IRA Deferred Tax Savings Example1
| 401(k) vs IRA Deferred Tax Savings Example1 | 401(k) | IRA | |
|---|---|---|---|
| Contribute Maximum Allowed | 401(k)
$23,000
| IRA
$7,000
| |
| Effective Tax Rate | 401(k)
25%
| IRA
25%
| |
| Personal Tax Savings for This Year | 401(k)
$5,750
| IRA
$1,750
| |
| Annual Employer 401(k) Cost | 401(k) - $1,140 (FYI this cost is tax deductible) | IRA
N/A
| |
| Tax Deferred Savings Less Employer Admin Cost | 401(k)
= $4,485
| IRA
$1,750
| |
1 Assumes a business owner under 50 years of age who pays taxes at an effective tax rate of 25% and owns a business with less than 10 employees. The example illustrates the difference in personal tax savings afforded via a 401(k) versus choosing to invest the maximum in a traditional IRA. The taxes are deferred until monies are withdrawn in retirement. You may pay more or less in taxes in the future than you do today. The example shows the tax savings difference both with and without the typical ongoing administrative price associated with the Safe Harbor plan type at ShareBuilder 401k for the owner’s perspective. Note that ShareBuilder 401k plan pricing is built to automatically change based on assets and number of employees. With the same number of employees and increased assets, plan pricing will lower at preset milestones.
Personally, you might pay $5,750 less in taxes in the current year, and you made a meaningful $23,000 contribution for your future too. Plus, if you offer a match in your 401(k) plan, the amount put toward retirement is even greater!
Tax Bracket Busting
Business owners without employees can have a 401(k) plan too. Known as a solo 401(k), these owners tend to have it easier in saving up to the annual $69,000 limit from taxes ($76,500 if 50 years of age or more) in their personal 401(k) account.
Owners and employees in non-solo 401(k) plans have the same high limits, it just can be more difficult to reach the maximum depending on how much your business is willing to contribute to all employees, the employee’s contributions and their income.
With a solo 401(k) plan, you are both the employee and the employer. You can contribute $23,000 per year as an employee if you like ($30,500 if 50 years plus) and/or profit share tax-deferred to yourself as the employer up to the $69,000 limit. Depending on your entity structure and the IRS calculation, you can also contribute up to 20%-25% of your earned income up to the $69,000 limit. And that is how starting a 401(k) could drop you a tax bracket.
Up to $16,500 in Tax Credits to Offset Your Plan Costs
If you are starting your business’ first 401(k) plan and have less than 100 employees, you can qualify for a minimum of $500 tax credit to a maximum of $5,000 for each of the first three years of your plan. For companies with 1-50 employees, the tax credit is for 100% of qualified business cost such as setup and monthly administration. For companies with 51-100 employees, this credit can be applied to 50% of your qualified business 401(k) costs. In addition, if you choose the automatic enrollment feature, you may qualify for another $500 per year for the first three years. That’s up to $16,500 in tax credits over the first three years to offset setup and administration charges for the maintenance of your plan. These credits can cover all your business costs for companies of 1-50 employees in most any scenario with a ShareBuilder 401k.
Here’s How It Works:
Your business must have at least one employee, besides you as the owner, who earns less than $155,000 a year (a Non-Highly Compensated or NHC employee) to qualify for a tax credit. The tax credit received is the greater of $500 or $250 per NHC employee with a cap of $5,000 applied to 100% of the costs you incurred.
So, let’s say you have 10 employees and your ShareBuilder 401k business cost is $1,200 annually. Your tax credit is $1,200 in year one, or $3,600 in total over the first three years assuming your business size and costs remain the same. Learn more.
A Terrific Match: Employer Contributions Are Eligible for Tax Credits and Tax Deductions
Giving your employees a 401(k) contribution, be it a match, profit share or other, is tax deductible for your business.
But now businesses with 1-100 employees can receive tax credits too! If you have less than 100 employees, you can qualify for tax credits of up to $1,000 per employee for your first 50 employees for your employer contributions. This applies for those employees earning less than $100,000 per year. The applicable percentage is 100% in the first (year plan begins) and second tax years up to $1,000 per employee, 75% in the third year, 50% in the fourth year, and 25% in the fifth year, and none for subsequent years. Note, there are some added tax credits for employees 51-100 as well, but a lesser percentage.
Lastly, for those contributions you receive a tax credit, those likely don't qualify for tax deductions. However, the amount not covered by the credit should be deductible. You'll want to review with your tax accountant.
While matching is optional, most small business owners with steady revenue choose to match for three reasons:
1. By matching, you (the owner) benefit right along with your employees since you are also an employee and thus receive the match.
2. A ‘safe harbor’ ensures that any employee and owner can give the maximum to the plan and automatically satisfies IRS discrimination testing avoiding those hassles.
3. Since the match is deductible, the employer contributions tends to be minimal true cost for the business; however, you will want to have the cash flow to manage the contribution each payroll.
Retire Tax-Free with Roth
If tax protection this year is not your primary concern, or you expect higher tax rates in the years to come, the Roth 401(k) option is something to seriously consider. A Roth 401(k) has no income limitation to participate unlike a Roth IRA. Anyone in your 401(k) program can put some, part, or all of their contributions post-tax into a Roth 401(k). Since these contributions were already taxed, this money along with any gains, will not be taxed when you draw from your Roth 401(k) in retirement. One thing to know however, is that all employer matching and profit-sharing is done on a tax-deferred basis only. This means that only personal contributions can be made towards a Roth 401(k) account.
As you look for new ways to pay yourself more, protect more of your money, and keep taxes in check, know that a 401(k) plan can help you along the way. To ensure maximum tax benefits, the earlier you start the better. The savings benefits might just last you a lifetime. And remember, it’s always wise to check with your tax advisor.