Small Business 401(k) Plans: What to Know as an Employer

A small business 401(k) is a popular—and meaningful—employee benefit many employers offer their teams. 

Specifically, a 401(k) is a company-sponsored, tax-deferred retirement plan that deducts contributions from employees’ paychecks and then deposits that money into their 401(k) accounts. 
When employees retire, they’ll receive regular distributions to supplant their income—and they won’t pay any taxes until then, as long as their 401(k) is funded with pretax dollars.

What is a 401(k)?

A 401(k) is a type of retirement account an employee can use to set aside a portion of their wages for long-term savings. Through a small business 401(k) account, both employer and employee can contribute; typically, the employer will match the funds the employee deposits into the account. That’s why these widely-sought retirement accounts are also called profit-sharing plans.

Employee contributions to a business 401(k) plan are tax-deductible, with designated Roth deferrals as the sole exception. All distributions from a 401(k) retirement savings plan (this means when the employee has retired and the money from the account is paid out), including earnings, are counted as taxable income upon retirement—and again, qualified distributions from Roth retirement accounts are the sole exception.

Note that an employer can set up a 401(k) but not the other type of retirement plan, an individual retirement account (IRA). Whether a simple IRA or a traditional one, these are handled entirely outside your place of business, so as a small business owner, you only need to concern yourself with 401(k) plans.

Do I have to offer a 401(k) as an employee benefit?

No, offering a 401(k) plan isn’t mandatory—although it’s a good way to increase employee retention.

Ensuring that your team feels confident with their retirement savings accounts can improve their job satisfaction and performance. The average 401(k) return is between five and eight percent. Comparatively, the average return on a 20-year government bond is currently 1.9%.

Just because you don’t have to offer a 401(k) doesn’t mean you don’t need to offer any retirement savings plans. Some states, like California, require certain employers to help employees save for retirement. 

You can typically fulfill these requirements with a 401(k), Roth IRA, or other type of retirement plan—and many states are developing public options that will fulfill your legal requirements.

Here are the states that require you to offer your employees a retirement plan.

What types of 401(k) plans can I offer my employees?

There are a number of different small business 401(k) plans out there. So it’s important to do some research so you can pick the one that best suits your company and employees. 

What types of 401(k) plans can I offer my employees?

There are a number of different small business 401(k) plans out there, so it’s important to do some research so you can pick the one that best suits your company and employees. 

You’ll need to answer a few questions before choosing the right 401(k) plan for your business. 

• Do you want to match your employees’ contributions? While you can match with a traditional 401(k), this also opens up the Safe Harbor 401(k) option, which doesn’t require annual compliance tests. (Every year, employers who offer retirement plans are required to complete tests that confirm they are not discriminating against certain employees.) A Safe Harbor 401(k) can help highly compensated employees max out retirement contributions. The SIMPLE 401(k) also requires matching your employees’ contributions.
• How big is your company? If your company only consists of you or you and your spouse, consider the solo 401(k), which has minimal compliance requirements. The SIMPLE plan, which also offers reduced compliance requirements, is a great 401(k) for small businesses with less than 100 employees.

You should also understand what the compliance requirements look like before picking a plan. Use the terms below to help you understand each plan’s requirements.

• Fiduciary duty: This means you are taking action to benefit your employees, so you must take on certain responsibilities on behalf of those employees, like: minimizing extraneous fees, submitting employee contributions on time, and disclosing relevant requirements to your staff.
• Nondiscrimination testing: This means that you have to make sure 401(k) contributions are proportional regardless of income level. Your highly compensated employees can’t contribute a significantly higher percentage of their income to their 401(k)s (which includes your employer match) than employees who earn less. 
• Form 5500: This IRS form reports on your plan’s investment, financial state, and operations. (We’ll get into this in the next section.)

You also might want to consider a Roth IRA or Roth 401(k), which deduct money post-tax. While Roth IRAs (individual retirement accounts) are designed for individuals, if you have employees, your company could offer Roth 401(k)s, which have the same contribution limits as a traditional 401(k), but are deducted from your employees’ paycheck after taxes. 

If a large number of your employees would prefer to have a Roth account, this might be something to consider. Learn more about the difference between a Roth 401(k) and a Roth IRA. 

You may have also heard about 403(b) and 401(a) plans, which are designed exclusively for nonprofits and government employers. If you fall into one of these groups, they may be a good fit.

Last, when considering which 401(k) plan is best for your business, you may want to look for these features, in particular:

• Low-fee investment options
• Easy 401(k) provider integration with your payroll software
• Personalized investing advice for your employees
• User-friendliness

If I offer a 401(k), what are my requirements as an employer?

Depending on your plan, the most important requirements are nondiscrimination testing, fiduciary duty, and submitting the proper tax form—Form 5500. 

Form 5500 is filed electronically via EFAST2, and is due the last day of the seventh month after the end of the plan year. For example, if your plan year ends December 31, Form 5500 will be due on July 31.

To submit Form 5500, you’ll need to know:

• If your plan is a single-employer plan or a multiple-employer plan that covers several companies. Multiple-employer plans are also referred to as association retirement plans, or ARPs.
• If the plan is collectively bargained
• The name of the plan
• The plan sponsor’s name—typically your company
• The plan administrator’s name—the company that manages your plan
• The total number of plan participants, including the amount who are active at the beginning and end of the plan year
• If any retired, separated, or soon-to-be retired or separated participants will receive benefits
• The number of deceased participants whose family still receives benefits
• The number of participants with account balances
• The number of employees who left your company and weren’t 100% vested
• Information on pension or welfare benefits, if provided

Your company might also receive tax benefits by offering a 401(k). The three major benefits are:

• An up-to-$5,000-per-year tax credit for the first three years you offer a 401(k) for costs incurred for administrations and startup of the 401(k) plan.
• Additional tax credit for qualifying Employer contributions to the 401(k) plan.
• Deductions of some administration fees
• Tax-exempt employer contributions, as long as they’re less than 25% of each employees’ total compensation 

How much does it cost to set up a 401(k) plan for a small business?

It can cost hundreds to thousands of dollars to set up a small business 401(k) plan. And these are just startup costs—administrative fees and quarterly charges can add thousands of dollars more to the price a small business owner pays to maintain their employees’ 401(k) accounts.

Costs vary depending on whether the retirement savings options your business offers are traditional or simple 401(k) plans. Excluding setup fees, a traditional plan is likely to cost thousands—or even tens of thousands of dollars annually—whereas a simple plan can sometimes cost just hundreds of dollars. The fees a small business owner pays for a 401(k) include costs for setup, administrative work, assets, investment advice, consulting, and per-participant charges. For specific dollar figures and an in-depth look at whether simple or traditional retirement plans are better for your business and employees, consult a financial advisor.

On the bright side, offering a 401(k) plan can save your business money on taxes. When you offer a 401(k) or other qualified retirement plan, your business may be eligible for a startup cost tax credit, which is officially called the Credit for Small Employer Pension Plan Startup Costs. This credit incentivizes small businesses to offer retirement plans to their employees by offsetting up to 100% of the plan startup costs capped at $5,000 annually for the first three years of the plan. An additional $500 is available for plans that offer auto-enrollment of employees. The Secure Act 2.0 also introduces an additional credit in tax year 2023 for employers who match employee contributions (max credit of $1000 for employees).
For eligible customers, Gusto offers a free 401(k) tax credit service to assess whether you qualify and automatically generate the required tax form. Learn more.

How much can employees contribute to their 401(k) plans in 2024?

The 401(k) contribution limit for 2024 is $23,000 for employees under the age of 50—although there are several caveats. First, employees over the age of 50 can contribute an additional $7,500, called a 401(k) catch-up, raising their total contribution limit to $30,500. 

Including employer contributions, the maximum 401(k) contribution amount for those under the age of 50 is $69,000 or 100% of an employee’s compensation, whichever is lower. For employees over age 50, this maximum limit is $73,500. 

The more your employees can contribute, the better—not only will it increase their retirement savings, but it will lower the amount of taxes they owe in April.

What is employer matching?

Once you’ve set up your 401(k), you might want to contribute to your employees’ plans. That’s great. But it can also be confusing. 

Many employers elect to match contributions up to a certain point. That means your contributions will be based on your employees’ contributions—although the exact terms are your decision. 

Your options include:

• Matching your employees’ contributions dollar-for-dollar until they reach a certain percentage of their salary. (Often 5% or 6%.) 
• Matching a certain percentage of your employees’ contributions. For example, you may match 50% of contributions up to 5% of your employees’ salaries—which means, in effect, you’re contributing up to 2.5% of your employees’ salaries.
• Contributing a flat amount to your employees’ 401(k) plans, like $5,000 per year. You can do this and match your employees’ contributions.

Keep in mind that some 401(k) plans, like the safe harbor 401(k) and SIMPLE 401(k), have specific employer-matching requirements. Check out the table above to see what those requirements are.

Still a little confused? Let’s walk through an example.

Jada makes $100,000 per year. Here’s how their 401(k) contributions would shake out with different kinds of matching, assuming they take full advantage of your company’s plan: 

• Dollar-for-dollar match, up to 6%: Jada contributes $6,000 per year and you contribute $6,000 per year for a total of $12,000 per year.
• Percentage match — 50% of 6%: Jada contributes $6,000 per year and you contribute $3,000 per year for a total of $9,000 per year.
• Flat contribution of $5,000: Jada contributes $6,000 per year and you contribute $5,000 for a total of $11,000 per year.

What are the 401(k) contribution limits for an employer match?

Your 401(k) matching contributions can’t exceed either 100% of your employees’ compensation or $69,000—whichever is less. 

The limit rises to $73,500 for employees over 50.

What is profit-sharing?

One unique way to contribute to your employees’ 401(k) plans is through profit-sharing. Essentially, a profit-sharing plan allows you to divide a portion of your business profits among your employees and add that money directly to their retirement savings. 

This is great if your company’s finances are in flux, and you’re not sure if you can contribute much to your employees’ 401(k)s on a regular basis. Or, if you want to encourage your employees to share in your company’s success, a profit-sharing plan can be a good motivator. 

If you choose a profit-sharing plan, you’ll need to be extra careful during your nondiscrimination testing. Often, employers allocate profit according to each employee’s share of total compensation—which means highly paid employees will receive more money.

Profit-sharing plans are limited to a maximum of 25% of the employee’s total compensation or $56,000, whichever is less. 

Not sure how you want to contribute? Here’s the rundown.

What is 401(k) vesting?

Whether you choose to match, offer a flat fee, or enroll in a profit-sharing plan, you’ll need to think about vesting. 

If your employee is “vested,” it means they own 100% of their retirement account, including your contributions—and you can’t revoke any money if they leave. Many companies require employees to work for a few years before their account is fully vested, which can incentivize an employee to stay.

The right vesting schedule depends on you and your business. Common vesting options include:

• 100% vesting immediately: Employees own the amount you contribute as soon as it hits their 401(k) account.
• Cliff vesting: Employees remain 0% vested until they reach a designated milestone, such as three years of service. Then, they’re 100% vested.
• Graded vesting: The amount your employees are vested increases every year. For example, in year two they might be 20% vested; in year three, 40%; and so on until they reach 100% vested. 

There are two occasions when an employee must be 100% vested: if they’ve reached the plan’s retirement age or if the plan is terminated. 

How do I handle 401(k) rollovers when an employee starts or leaves?

If your employee leaves the company, many retirement plans won’t allow them to keep their funds in the same place. They’ll need to roll over their 401(k) into a personal IRA or their new employers’ 401(k) plan. 

Generally, your employees will handle their own 401(k) rollovers directly with the plan administrator. 

What’s the difference between a 401(k) and a pension? 

Before small business 401(k) plans became common in the 1980s, many employers offered pensions, which guaranteed a certain amount of income after employees retired. 

Unlike 401(k)s, which are a contribution plan—meaning your employees contribute to their own retirement savings—pensions were a benefit plan. That means the employers were often exclusively contributing, although some plans did require employees to participate, too.

Typically, employees would receive a set, guaranteed amount after retirement, delivered either as a lump sum or as regular income. Generally, employees would have to work at the company for a specific amount of time, such as 15 years, before receiving the full payment.

Often pensions came with conditions, like requiring employees work at least 10 years or providing a set portion of their salary—perhaps 50% or 85%. When pensions fell out of favor, 401(k) plans became popular. 

How do I set up a 401(k) for my small business?

See this 401(k) set up guide for a walk through on how to implement this program in your business. To start, you may want to call 401(k) providers’ sales teams as you compare and contrast plans—even the most thorough research may leave you with questions that only a sales team can best answer. 

Your employees can save with 401(k) plans, and you’ll benefit too

Offering a 401(k) is a fantastic way to help your employees save for retirement. These plans can also help you lower your tax burden—a win-win for everyone.

Originally published: November 12, 2019