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 2022, you can contribute up to $20,500 tax-deferred into a 401(k) plan ($27,000 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 $20,500 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|| |
|Effective Tax Rate|| |
|Personal Tax Savings for This Year|| |
|Annual Employer 401(k) Cost|| |
(FYI this cost is tax deductible)
|Tax Deferred Savings Less Employer Admin Cost|| |
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 The taxes are deferred until monies are withdrawn in retirement.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 $5,125 less in taxes in the current year, and you made a meaningful $20,500 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 $61,000 limit from taxes ($67,500 if 50 years of age or more) in their personal 401(k) account.
With a solo 401(k) plan, you are both the employee and the employer. You are able to contribute $20,500 per year as an employee if you like ($27,000 if 50 years plus) and/or profit share tax-deferred to yourself as the employer up to the $61,000 limit. For your employer contribution or profit share, if you are a sole proprietor, LLC or partnership, you can also contribute up to 20% of your net Schedule C up to the limit $61,000 limit. If your business is a corporation, it’s 25% of your earned income that you may contribute to your account up to the limit. And that is how starting a 401(k) could drop you a tax bracket.
Another great thing about solo 401(k)s is that they aren’t just for owners. Spouses and other business partners can also be part of the plan. However, once you add full-time employees beyond owners, you will need to convert your plan to an employee-based 401(k).
Note 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.
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. This credit can be applied to 50% of your qualified business 401(k) costs such as plan setup and administration. In addition, if you choose the automatic enrollment feature, you 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 more than half the business costs of your ShareBuilder 401k in most every scenario.
Here’s How It Works:
Your business must have at least one employee, besides you as the owner, who earns less than $135,000 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 50% of the business costs you incurred. You likely will not earn the full amount of this tax credit because our ShareBuilder 401k plan costs are pretty darn low. The automatic enrollment tax credit is not beholden to the 50% of business cost rule, so you can earn $500 tax credit just by adding this feature.
Let’s take an example where you have 9 NHC employees and your ShareBuilder 401k business costs are $1,140 per year, you just qualified for $570 in tax credits for this year or $1,710 over three years. If you include automatic enrollment with your plan, your tax credit increases to $1,070 this year or $3,070 over three years. Your net cost would be $70 annually the first three years of your plan after these two tax credits are applied.
For businesses with <50 employees, employer paid costs will typically be less than $800 per year with a ShareBuilder 401k once both tax credits are applied for the first three years of your plan. Learn more.
A Terrific Match: Employer Contributions are Tax Deductible
Giving your employees a 401(k) contribution, be it a match, profit share or other, is tax deductible for your business. 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.