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Lower Your Taxes with a 401(k) Plan

An incentive to save

401(k)s are designed with some great tax advantages that can benefit you this year and well into the future. In fact, it may even cost your business less than not having one at all.

Tax breaks at-a-glance

  • $500 tax credit if it's your first 401(k) plan and you have employees
  • Matching, profit sharing and admin fees are deductible for your business
  • Contribute up to $18,000 tax-deferred in 2016 plus any matching you receive
  • You can choose to contribute after-tax into a Roth 401(k) – no income limits – which will not be taxed again when withdrawn after age 59½

How much you might save

In the simplest scenario, when an owner contributes the 2016 maximum of $18,000, she or he protects $4,500 from taxes this year! Keep more money for yourself while putting money to work for tomorrow. That tax savings more than covers the cost of a ShareBuilder 401k – to the tune of 2.4 to 4.6 times for companies with 25 or fewer employees. The savings cover the cost by a lot more for an owner-only business.

Less taxing, more saving — 3 scenarios

Yes, 401(k) tax advantages can really add-up. To expose the ins and outs of both the business and personal savings, we created three scenarios. We based these very real scenarios on our experience working with businesses owners. The three scenarios simply consider a business with seven employees (including the owner) that offers:

  1. No 401(k) Plan
  2. A 401(k) Plan with no company match
  3. A 401(k) Plan with a 4% match for participating employees (Safe Harbor)

So how do these scenarios compare at the end of Year One? Pretty great if you have a plan. The owner who matches is much better off than the owner without a plan. Even the owner with a plan who does not match is better off than the owner without a plan.

While your after-tax pay will be lower, the owner that matches gains:

  • $2,729 more than an owner without a plan
  • $7,465 reduction in federal taxes, and
  • $22,087 in tax-deferred income!

That's just Year One. Tax credits, deductions of any match and plan expenses, and receiving a match can all have powerful effects on your bottom line.

Year One Comparison
  No 401(k) Plan 401(k) Plan
No Match
401(k) Plan
With Match
After-Tax Income + Retirement Savings $108,893 $110,800 $111,622
Total Tax Liability (business + personal) $41,107 $38,060 $33,638
Retirement Savings $8,932 $22,087

 

Assumptions: This is a mouthful, so get ready (see the Appendix for scenarios breakouts).

  • Proprietorship's net income is $150,000
  • Owner is in the 25% tax bracket (using 2010 tax tables)
  • 4 employees, including the owner, participate in the plan
  • Average participating employee salary is $30,000, not including owner
  • Owner is married, taking standard deduction and exemptions
  • Owner in No Match plan can only contribute up to 6% of salary
  • Owner in Matching plan puts in the $16,500 maximum, plus receives the 4% match

Why doesn't the No Match owner contribute more?

Great question! One reason is obvious: the owner doesn't receive any matching. Another is based on 401(k) rules. Owners who don't match often have their contributions restricted within their individual account by how much the participating employees contribute on average (more specifically, by those employees who earned less than $120K in the previous year).

Since our example assumes participating employees give 4% of salary, the owner can contribute up to 6% of his or her own salary.

Tax savings swell over time

Look ahead a few years to see how tax savings can stack up. The chart below demonstrates that your tax savings grow even without changing the amount owners save and keeping their tax rates constant. Granted, tax rates will likely change or expire, which could very likely increase your tax liabilities.

Taxes Add Up
  Year One Taxes Cumulative Taxes
Over 5 Years
Cumulative Taxes
Over 10 Years
No 401(k) $41,107 $205,533 $411,066
401(k) no match $38,060 $190,299 $380,597
401(k) with match $33,638 $168,189 $336,378

 

In just 10 years, the owner with a match saves $74,688 in business and personal taxes compared to the owner without a 401(k).

Become a millionaire in 25 years or less

Tax savings are a powerful reason to start a 401(k) today. But the real secret sauce is putting your money to work building a healthy nest egg. As compelling as tax advantages are today, combining compounding interest and the high contribution amounts allowed in a 401(k) may be the biggest helping hand you ever get. A genius in understanding forces and time, Albert Einstein declared, "the most powerful force in the universe is compound interest."

So let's see what the nest eggs might look like for our scenarios. Assume the owner's contribution remains the same each year and the contributions attain a 7% net return over time. For one last perspective, we added a scenario for the "No 401(k)" owner who puts some money in a Traditional IRA (individual retirement account).

See the following chart to find your million1:

Nest Egg Comparison
  Year 1 Year 10 Year 25
No 401(k) – not saving
No 401(k) – putting $5.5k a year in an IRA $5,500 $75,990 $347,869
401(k) no match ($8,932 contributed/year) $8,932 $123,403 $564,915
401(k) with match ($16,500 contributed +
$5,587 match per year)
$22,087 $305,163 $1,396,977

 

The owner who matches is sitting pretty with a cool $1.4M in 25 years.

Less taxes, more savings. Does it get much better in the world of business? Helping customers succeed may be about the only thing that can top it.

You see the difference above in the owner using an IRA versus a 401(k). The advantages of a 401(k) compared to a traditional IRA are substantial. Take a close look at how an IRA compares:

401(k) Towers Over IRA
  401(k) IRA
2016 contribution limit $18,000 $5,500
Age 50+ catch-up amount $6,000 $1,000
Roth income limit None $132K2
Penalty-free access, if needed Yes, via a loan No

 

More resources

  • Tax Advantage Breakdown: To dive into the details of the tax comparison, check out the following Appendix section which walks through important assumptions and goes line by line through the Year One tax comparisons. It's always a good idea to speak with a tax advisor about your unique situation.
  • 401(k) Loans: Some nice advantages over other loan options. They also have some real poison pills to watch out for. Get the whole scoop in 401(k) Loans: the Good, the Bad and the Ugly.
  • The Real Cost of Employee Turnover: Good times or bad, the cost to replace your most valuable employees is higher than most people think. Check out how a 401(k) may help keep these costs in check.

We're always happy to help. Call us today at 1.800.943.6108, option 1, to speak with a 401(k) Consultant.

Appendix — tax advantage breakdown

The following chart gives a breakdown of tax savings for three identical, hypothetical companies.

Sample company profiles

  • All are proprietorships
  • All have seven employees including the owner
  • All have an owner earning $150,000 salary annually
  • Companies with a 401(k) have three employees plus the owner participating
  • Average participating employee (not including owner) earns $30,000 annually
Assumptions

  • Tax calculations are based on 2010 tax rates and rules
  • You'll consult a tax specialist to assess your business and personal situation
No Match plan = owner restrictions

401(k) rules limit how much an owner (and any other highly compensated employee) can contribute to their own plan. In the "No Match" scenario, the owner can only contribute 6% of his or her salary into the 401(k) account. In a "Safe Harbor" plan, which requires a match, the annual contribution limit of $18,000 is the only restriction.

Tax breakdown — 3 scenarios

Taxes and 401(k) Ownership
  No 401(k) Plan 401(k) Plan
No Match
401(k) Plan With
Safe Harbor Match
Owner's Net Income $150,000 $150,000 $150,000
    401(k) plan annual administration ($1,140) ($1,140)
    401(k) matching for employees ($3,600)
    401(k) matching to self/owner ($5,587)
Adjusted Net Income
paid as distribution to owner
150,000 $148,860 $139,673
401(k) Plan Tax Deductions      
    401(k) owner savings ($8,932) ($16,500)
Net Income
after Schedule C retirement plan expenses
$150,000 $139,928 $123,173
    self-employment tax up to limit $106,800 (15.3%) $16,340 $16,340 $16,340
    self-employment tax after limit (2.9%) $1,252 $1,219 $953
    minus one half of self employment tax $141,203 $131,148 $114,526
    standard married deduction and exemptions ($17,900) ($17,900) ($17,900)
    income subject to federal income tax $123,303 $113,248 $96,626
    federal income tax amount $23,513 $20,999 $16,844
    federal tax credit for new retirement plans
    (available first 3 years of plan)
($500) ($500)
    total cash available after taxes, not including
    retirement savings
$108,893 $101,869 $89,535
Total Remainder After Taxes
including retirement savings
$108,893 $110,800 $111,622
    total tax liability (self employment +
    federal income tax - credit)
$41,106 $39,060 $33,637
    personal retirement savings $8,932 $16,500
    company match for self $5,587
Total Retirement Savings for 2011 $8,932 $22,087

 

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