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A growing number of states require businesses to implement a retirement program for their employees. It’s crucial that you help your small business clients through the process of incorporating retirement packages and explain the benefits of state IRA plans and 401(K)s.
Gusto, along with our partners at CPA Academy, delivered a great webinar all about the advantages and disadvantages of 401(k)s and state IRA plans. We presented the webinar, “Private Sector 401(k) vs. State-Sponsored IRA: A Guide for Accountants, “hosted by Nicolle Wilson. She is the director of the retirement consulting department at Guideline.
In addition to this webinar article, which is Part Two of the series, you can also read Part One and Part Three to learn about the history of 401(k)s as well as 401(k) enrollment and pricing. You can also watch the full presentation here.
In this article, we’ll share critical insights from Nicolle’s webinar presentation, including the difference between IRAs and 401(k)s, 401(k) tax benefits, the pros and cons of using a state IRA program. We will also cover which retirement plan your small business clients should implement.
What is the difference between an IRA and a 401(k)?
Many states require businesses to offer retirement plans to their employees. Both 401(k)s and state IRA plans are great options for fulfilling the retirement program mandate. As an accountant, it’s important to inform your small business clients about the different advantages and disadvantages of utilizing 401(k)s and state IRA plans.
401(k)s are employer-sponsored plans in which employees invest part of their income into an account. With 401(k)s, employers can contribute to their employees’ accounts, which also offers potential tax benefits to their companies.
Individual Retirement Arrangements (IRAs) are accounts in which employees invest money towards retirement, but employers cannot contribute to employee IRAs.
401(k) tax benefits
When advising your small business clients, you should describe the potential tax benefits of implementing a 401(k) program. One obvious benefit of 401(k)s is more financial security for employees. When a business offers excellent benefits—such as a 401(k)—they’re able to attract quality employees:
Having a 401(k) plan gives you a competitive advantage against 90% of other small businesses for recruiting and retention. There have been studies that show most workers will pick a company with better benefits, including 401(k) benefits, over a company that just offers higher pay with no benefits. … A 2017 study by the Employee Benefit Research Institute also found that almost six in 10 workers who are extremely satisfied with their benefits are also extremely satisfied with their jobs.– Nicolle Wilson
Retirement benefits are critical for employee satisfaction and enable your small business clients to recruit and retain excellent employees.
In addition to employee satisfaction, 401(k)s also offer tax savings for individuals and businesses. Employers that implement a 401(k) program receive a valuable tax credit in the first three years of starting a new plan. Additionally, contributing to employee 401(k)s is a more cost-effective way to offer employees bonus compensation:
[Employers] have the ability of making employer contributions in the form of either matching or profit-sharing to the plan. Employer contributions are more tax-efficient than an outright bonus, and you generally end up with the employee getting more money out of that same nominal contribution. Employer contributions are free of federal and state income tax [and] payroll taxes to the employer. Also, they are not reported as income to the employee in the year made.– Nicolle Wilson
Both employers and employees benefit from contributing to 401(k)s. The quality retirement plan gives employees automatic savings by drawing from their wages. Employees set their contribution rate for their 401(k)s, and that percentage is taken out of each paycheck.
Disadvantages and benefits of an IRA
State IRA plans have similarities to 401(k)s, including employee contribution withholdings, but unlike 401(k)s, employers cannot contribute to employee Roth IRAs:
States generally won’t charge anything to the employer to set up or maintain the plan. Since it’s a Roth IRA plan, employers are not allowed to contribute to the accounts. The plans will also follow all the distribution rules for Roth IRAs. … All plans require auto-enrollment.– Nicolle Wilson
A major benefit of state IRAs is that the plans only require minimal management from employers. 401(k)s require a great deal more management, so businesses will often allocate 401(k) management duties to a plan administrator.
Although state IRAs require less employer maintenance than 401(k)s, employers still need to perform actions to enroll and maintain their employees IRAs:
Under a state IRA program, employers will need to distribute plan information including timely notices to employees, take care of enrollment and onboarding, process payroll deductions, and remit employee contributions. On top of that, employers are expected to stay compliant with all the specific state programs, guidelines, or requirements.– Nicolle Wilson
A major disadvantage of using a state IRA plan is that employees cannot save as much towards retirement as a 401(k). As of 2021, employees can only save $6,000 a year in their Roth IRA account, and employees over the age of 50 can save an additional $1,000. Individuals can save almost three times that amount with 401(k)s, which allow people to save up to $19,500 annually.
Another important factor to consider when determining whether your client should implement a state IRA program is income. People earning over $125,000 in modified adjusted gross income are not qualified to make Roth contributions, and those who made over $140,000 are not eligible to contribute to a Roth IRA.
401(k) vs. IRA
There are many factors to consider when advising your clients whether to adopt a 401(k) or state IRA program. Ultimately, the decision will most likely come down to what features your small business clients need:
401(k) plans will have more flexibility with how you can contribute as well as higher limits. They’ll also allow businesses more flexibility in deciding plan features and investment choices. However, you have to be prepared to pay more for a 401(k), whereas, with [a] state IRA, you’re not really paying anything at all. … You need to put in the necessary work to keep [401(k)s] running properly.– Nicolle Wilson
401(k)s offer valuable features to small businesses, but they’re also more expensive to implement and require more management from employers.
Another factor to consider when fulfilling retirement mandates is the accessibility of finances. It’s far easier for employees to access IRA funds than 401(k) funds:
On the participant’s side, it’s harder to get money out of your 401(k) than from your IRA if you’re not in retirement. … State IRA programs are going to be pretty rigid in their structure, but they will allow employees to access their funds at any time.– Nicolle Wilson
Nicolle recommended that small businesses consider the price differences when choosing between a 401(k) and a state IRA program. 401(k)s are more costly, but they offer better benefits than state IRA programs:
Business owners looking for a robust retirement savings plan for employees, including for themselves, should choose a 401(k), and business owners that are looking to follow the mandate without any additional cost to the business should really just go with the state [IRA] program.– Nicolle Wilson
Bottom line: 401(k) plans offer more potential benefits than state IRA plans, but 401(k) plans are also more expensive and require more management.
Learn more about 401(k)s and state IRA plans
401(k)s and state IRA plans feature different benefits available for your small business clients. When determining the right plan for their business, your clients need to consider that employees can save a great deal more money towards retirement using a 401(k) plan, but 401(k) plans will also cost their businesses more money and resources.
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