Retirement Planning for Small Businesses
In the past, many small business owners have thought that providing a 401(k) plan wasn’t realistic for their employees. Perhaps they felt they were too small, that the plans were too expensive, or that the administrative burden was just too high.
Luckily, this is no longer the case, and not only is it possible—and affordable—for companies of any size to start providing a savings plan, but getting an early start is also advantageous from a tax-saving perspective.
A recent Glassdoor employment confidence survey found that 31% of workers value a 401(k), retirement plan, and/or pension over more than a pay raise.
Approximately two-thirds of workers not saving for retirement say they would be likely to save for retirement if their employer used automatic paycheck deductions at either 3% or 6% of salary.
In 2018, workers can make tax-deductible contributions of up to $18,500 to a 401(k).
The other good news is that in this tight job market, offering a workplace retirement plan is a great way to make your business stand out from the competition. However, it’s not just employees who can draw huge benefits: as it turns out, employers can also reap some incredible tax credits and deductions for providing a 401(k).
Did you know that there’s a tax credit for setting up retirement plan at your company?
The Credit for Small Employer Pension Plan Startup Costs allows eligible employers to claim a tax credit of up to $500 per year for qualifying costs to setup and manage a workplace retirement plan. While the name of the credit may seem restrictive, the IRS defines a small employer as a business with 100 or fewer employees who each received at least $5,000 in compensation for the previous year.
The tax credit for setting up a 401(k) is 50% of setup costs up to a maximum of $500 per year. Unlike a tax deduction, a tax credit reduces your tax liability on a dollar-for-dollar basis. You can claim this credit for each of the first three years of the plan, start claiming it in the tax year prior the plan becoming effective, and can carry it back or forward to other tax years if you can’t use it in the current year. This means that you can potentially eliminate up to $1,500 in taxes!
In addition to the costs for setting up and administering a 401(k), you can also include expenses to educate your employees about the plan. Just make sure that whatever expenses you include in Form 8881 to claim this credit, you leave out from your list of deductible business expenses.
Other Requirements: To qualify for the credit, at least one plan participant must be a non-highly compensated employee (i.e., someone who has never owned more than 5% of the business at any time, received more than $120,000 in compensation, or fallen in the top 20% compensation). Employees also may not have received contributions in another workplace savings plan at the same business within the three years.
The biggest win-win? There’s also tax deductions for 401(k) employer contributions!
Every dollar a company contributes to employees’ 401(k) plans is tax deductible, including matching contributions. While there is a cap on the amount a company can offer (25% of total compensation of all employees), this can still be a huge opportunity to save. From a tax perspective, contributing to an employee retirement plan is an effective way to reduce the amount of taxes that both the employer and employee have to pay.
Let’s imagine that you have the option of giving an employee $5,000 as either a lump-sum payment or as a contribution to her 401(k). The average American effective tax rate is 29.8% (as of 2016), and we can estimate the average employer payroll tax at 8.9%. At that rate, an employer would have to pay an average of $445 in taxes and an employee would only see an average of $1,490 in her pocket. Not an ideal outcome for either party.
On the other hand, a $5,000 employer contribution into a 401(k) allows the employee to receive the entire $5,000 and defer taxation until retirement when he or she is more likely to be in a lower tax bracket. In addition, the employer is able to deduct the entire $5,000. As a matter of fact, most employers can deduct up to $67,500 (25% of $270,000, which is the maximum compensation taken into account per employee) of 401(k) contributions for each qualifying employee.
Matching contributions from your employees doesn’t go unnoticed: 73% of workers not currently saving for retirement say they would be at least somewhat likely to save for retirement if employers matched their contributions.
What about costs?
There is the myth that providing a workplace retirement plan is expensive. The reality is that employer costs for retirement and savings plans tend to be lower than that of other perks and benefits.
According to September 2017 data from the U.S. Bureau of Labor Statistics (BLS), insurance benefit costs and retirement and saving costs averaged $2.68 and $1.39, respectively, in the private sector. On the average, businesses pay about half for retirement benefits than what they pay for insurance benefits. In the same period, the average cost for a defined contribution plan, such as a 401(k), was even lower at $0.75 per hour.
The cost of running a retirement and savings plan is even lower for a small business.
Companies with 49 or fewer employees spent an average of $1.32 (goods-producing industries) and $0.62 (service-providing industries) out of total hourly compensation per employee toward providing retirement and savings plans. When you look at it on an hourly basis, retirement plan costs are consistently lower than those of insurance, paid leave benefits, and legally required benefits.
This only reinforces the BLS data that shows offering a workplace 401(k) is a cost-effective way to lower your tax bill.
A Note On State-Sponsored Retirement Plans
Another good reason to consider running your own retirement plan is that many states, including Oregon, Connecticut, California, and Illinois, are in the planning stages or have already rolled out retirement plans of their own.
For example, beginning April 2018, all Oregon-based employers with 50 to 99 workers have to register their employees on OregonSaves, a Roth IRA retirement savings plan. In simple terms, employers currently not offering a workplace retirement plan have to enroll their employees (unless those employees opt-out) on OregonSaves by the deadline or face a penalty. Businesses with existing retirement plans just need to report to the State of Oregon that they already have one in place.
While the intent of this and other state-sponsored retirement plans is good, a one-size fits all retirement approach isn’t necessarily the best for the unique financial needs of your employees. Under most of these state-sponsored plans, the default choice is a Roth IRA which workers can contribute only an after-tax basis. Some of those plans don’t even offer a traditional IRA option at all! A worker looking for a way to reduce his or her taxable income would do better with a traditional IRA or 401(k).
Under state-sponsored retirement plans, employers won’t be able to contribute to the employee plans and thus will miss out on the opportunity for tax breaks.
Employer Forms for Deduct 401(k) Contributions
Sole proprietors and individuals deduct employer contributions on Schedule C of Form 1040, owners of partnerships deduct them on Form 1065, and owners of corporations deduct them on Form 1120 or Form 1120S.
A quick note to individuals (sole proprietors, side-giggers, and freelancers…etc.): A single participant 401(k), also known as a solo 401(k), is a great way to make up for low contributions in previous years or ramp up savings when you are close to retirement. With a solo 401(k) you can contribute up to $18,500 ($24,500 if you’re age 50 or older) as an employee and 25% of your net self-employment income as an employer. In 2018, you can contribute up to a total $55,000 ($61,000 if age 50 or older) to a solo 401(k)!
To learn more about how much you can deduct from your employer contributions to a 401(k) and other types of retirement plans, you can find more info in Publication 560.
The Bottom Line: A Retirement Plan = Savings for Everyone
Attracting and retaining top talent is a must to run a successful business, especially in the current competitive job market. An employer-sponsored retirement plan is a benefit valued by workers and one that reduces their taxable income, in addition to helping provide employers with tax credits and deductions to set up, manage, and contribute to those plans. Contact Thomas Huckabee CPA today, for more information with a free consultation.