New tax breaks and other developments make launching a startup 401(k) plan for employees a more viable option for small businesses.
- A 401(k) is an employer-sponsored savings plan that companies can offer to help employees save money for their retirement.
- Small businesses have always been permitted to set up a 401(k) plan for their employees, but new tax incentives and other changes make a startup 401(k) plan more attainable.
- Small business owners should look at a variety of factors, from fees and transparency to account-holder services and beyond, when shopping around for a startup 401(k) plan.
- This article is for small business owners who want to understand the basics of introducing a startup 401(k) plan.
Until recently, many small businesses shied away from offering a 401(k) plan to their employees based on financial constraints and other concerns. Fortunately for small business owners, startup 401(k) plans now lie within easier reach, thanks in large part to legislative changes and the increased availability of small business-oriented 401(k) plans. If you are considering offering a 401(k) retirement savings plan to your employees, it is important to understand what they are, how they work and how to go about starting one.
What is a 401(k) plan?
Introduced in the 1980s, a 401(k) retirement plan is an employer-sponsored plan that allows employees to contribute a portion of their wages to an investment account they can use when they retire.
Any small business with at least one full-time staff member (other than the owner) is eligible to set up a startup 401(k) plan. There are two options for this plans:
- A traditional 401(k) plan is funded with pretax money (gross earnings). Funds are deducted from employees' paychecks before federal, state and other taxes have been taken out. Taxes are taken out when withdrawals are made.
- With a Roth 401(k) plan, contributions are deducted from employees' net pay – after taxes have been taken out. Since taxes are taken out when contributions are made, the money is not taxed when withdrawals are made.
Key takeaway: A 401(k) is an employer-sponsored retirement savings account for employees. A small business owners with at least one full-time employee can offer a startup 401(k) plan. Traditional 401(k) accounts are funded with pretax (gross) earnings, and Roth 401(k) accounts are funded with net earnings.
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How does a 401(k) work?
When enrolled in the 401(k), an employee designates a percentage or dollar amount of their earnings to be withheld from each paycheck and deposited into their retirement account. Deducted funds are sent to a third-party administrator (TPA), who invests the money based on the employee's wishes, said Robert Pyle, owner of Diversified Asset Management. Some employers choose to match employees' 401(k) contributions to their plans as an incentive for their staff to participate in the program.
The money then stays in the retirement account until employees decide to withdraw their funds. If they do so before the age of 59.5, they are subject to an early-withdrawal penalty. If an employee leaves, they take the money they saved with them. However, if a matching contribution with a vesting schedule is part of the program, they might not be able to take all of the employer contributions with them. [Need an employee retirement plan for your business? Check out our recommendations for the best employee retirement plan providers.]
A traditional startup 401(k) plan has annual administrative and recordkeeping costs that are typically between $500 and $3,000, depending on its features and the number of participating employees.
"In general, a company with fewer than 10 employees will [incur] a cost of around $1,200 to $1,500 per year for plan administration, plus some small investment fees," said Adam Bergman, president of IRA Financial, a nationwide provider of self-directed IRA and 401(k) plans. "These costs are tax deductible to the business."
Key takeaway: Employee participants in a 401(k) plan decide how much will be deducted from every paycheck. A TPA deposits the money into each employee's 401(k) account and invests it based on that individual's instructions. For employers, the cost of offering a 401(k) plan generally ranges from $500 to $3,000.
Why is a startup 401(k) plan more attainable for small businesses now than before?
There are several new benefits for small businesses that make offering employee retirement plans a more attractive option.
In January of 2020, the new SECURE Act (Setting Every Community Up for Retirement Enhancement) increased tax credits for businesses that set up a 401(k) plan.
The act brings a tenfold bump to the tax credits that businesses with 100 or fewer employees can claim for qualified setup and administrative costs associated with startup 401(k) plans. The bigger offset – a tax credit of up to $5,000 – makes startup 401(k) expenditures easier to bear.
Under previous laws, the tax credit for the first three years of a startup 401(k) plan was 50% of qualified startup costs, not to exceed $500. Under the SECURE Act, the tax credit limit "is the greater of (1) $500 or (2) the lesser of (a) $250 multiplied by the number of non-highly compensated employees (HCEs) eligible for plan participation, up to $5,000," according to Alan Schoenberger, principal at Endeavor Financial Planning LLC.
Qualified startup costs include the costs to set up and administer the plan and to educate employees about it.
For the 2020 plan year, the IRS considers an HCE to be any individual whose compensation was more than $130,000 in 2020.
"The more non-HCEs you have, the higher the tax credit, up to the $5,000 maximum," Pyle said. "The credit can be claimed for three years."
Additional tax breaks push the envelope. Businesses can now earn an additional $500 credit by adding an automatic contribution feature or arrangement to a startup 401(k) plan (or an existing one, for that matter). This lets employers automatically enroll eligible employees in the plan. In order to not participate, employees would have to specifically opt out. A business can take the credit for having automatic enrollment each of the first three tax years in which it uses the feature.
Retirement Planology provides this example of how the credit would work out for a small business that has 15 non-HCE employees and opts for automatic enrollment:
- 15 non-HCEs x $250 = $3,750, the company's maximum tax credit per year
- Startup costs of new plan: $4,500
- 50% of $4,500 = $2,250
- Auto-enroll plan credit: $500
- Total credit per year: $4,500 - $2,250 - $500 = $1,750
- Cumulative credit for the three years: $1,750 x 4 = $5,250
There is a caveat: Employers cannot set up a second retirement plan to get more tax credits.
"The credit is only available when an employer is establishing a new retirement plan, including 401(k) plans, 403(b) plans, profit-sharing plans, cash balance plans, SIMPLE IRAs and SEP IRAs," said Colin Exelby, president and founder of Celestial Wealth Management. "If, during the previous three years, the employer offered a retirement plan that covered substantially the same employees as the new plan, the tax credit is not available."
In the past, most 401(k) plans came with hefty administration fees based on a percentage of assets under management. It's more common now for plan administrators to be paid a fixed amount per plan participant, keeping costs more manageable. Additionally, there has been an explosion in the number of available 401(k) plans designed specifically for small businesses.
Modern 401(k) providers provide online savings calculators and online access to plan details, minimizing the physical paperwork and telephone conversations involved in managing 401(k) plans.
Key takeaway: A tenfold increase in tax credits for the cost of startup 401(k) plans, as well as better pricing and easier management, makes these plans more reasonable investments for small and midsize businesses.
How do I start a 401(k) plan for my employees?
If you are interested in offering a retirement savings plan to your employees, you need to follow these steps:
1. Figure out your service provider strategy.
There are three major players in a 401(k) plan strategy, according to Bergman: the TPA, the recordkeeper and the investment advisor.
"The TPA designs the plan and handles all plan testing and IRS reporting," Bergman said. "The primary purpose of a recordkeeper is to keep track of the plan money, and the investment advisor helps the plan trustee (business owner) select investments to offer plan participants. A business owner can use one company that offers a bundled approach, or multiple companies – it's a matter of personal preference."
2. Decide whether to offer an employer matching contribution.
Employers aren't required to contribute to employees' 401(k) accounts. However, many make a matching contribution to incentivize employees to participate.
The average employer match is about 3% to 4.7% of the employee's salary. For example, if an employee decided to make a 5% contribution, the employer would add another 3%. This brings the total amount the employee is saving for their retirement to 8% of their salary.
Employers that offer a matching contribution must also determine whether they want it to have a vesting schedule. A vesting schedule prevents an employee from taking the money and leaving for a new employer after only a short period with the employer making the matching contribution.
For example, a vesting schedule might last three years. Each year of employment, an employee would become 33% vested. That means, if they leave after just one year on the job, they would take all of their contributions to the 401(k), plus 33% of what the employer contributed. After three years, they would be fully vested and eligible to take all of the contributions should they leave for a new job.
3. Shop around carefully for a plan provider.
The best providers offer these features:
- Transparent pricing: "I cannot stress this enough," Schoenberger said. "There are many 401(k) providers that try to bundle costs together, which can make it difficult to determine what you are truly paying for the plan."
- Simple setup: Look for a plan that offers easy setup options, with limited paperwork and the flexibility to do much of the work online.
- Payroll integration: "A 401(k) plan should have the highest level of integration to and from payroll/paychecks," said Brian Halbert, owner of Halbert Capital Strategies. "This saves time and headaches for small business staff."
- Compliance support: The provider should ensure your plan's compliance with IRS regulations and the Employment Retirement Income Security Act of 1974. The U.S. Department of Labor explains ERISA as "a federal law that sets minimum standards for most voluntarily established retirement and health plans in private industry to provide protections for individuals in these plans."
- Flexibility: Look for a provider that gives you access to a wide assortment of fund options, allowing you to design the right plan for your company.
4. Create your plan documents.
A TPA typically handles this step. The documentation should include information on when employees are eligible to participate in the startup 401(k) plan, any pertinent details about employer matching and profit sharing, a description of plan distributions, and contact information for the employer, TPA, recordkeeper, and investment advisor.
Ensure that this information is correct and readily available. You'll need it for future reference and, more importantly, to demonstrate your compliance if you face an IRS audit.
5. Get the word out.
Depending on your plan, you may need to let eligible employees know that it's available before it goes into effect – typically 30 days prior to the effective date.
Key takeaway: When you're ready for a startup 401(k), decide if you want to use multiple companies or one to handle everything, and whether you want to match employees' contributions. Then, look for a plan provider that offers transparent pricing, easy setup, integration with payroll, compliance support and an assortment of plans.