The tax benefits of employee contributions to a 401(k) are well-known. The money an employee puts into a company-sponsored retirement plan is either taken out of that year’s taxable income (in the case of a traditional plan) or withdrawn tax-free (in the case of a Roth).
Offering a 401(k) plan can help your company attract top talent. Employees look for companies that offer strong benefits packages, and that includes retirement plans. Even better, there are a number of ways to help your employees meet their retirement goals while keeping the costs of the plan affordable.
In fact, many employers match a portion of the employee’s contribution, giving them an extra boost toward their retirements. This offers tax advantages to both the employees and the employers, and we’ll discuss the details below. However, this is where the tax implications get a little murky: can employees deduct employer contributions alongside their own? Can companies reduce their own tax bills by matching contributions? We’ll explore the tax implications of matched 401(k)s from the employee and employer perspective to make sure that 401(k) tax deductions are as clear as they can be.
What Is a 401(k) Match?
Employees can contribute up to $19,500 to their 401(k) in 2020 ($19,000 in 2019), or up to $25,500 if they’re over 50 years old (see 401(k) contribution limits). Employers can offer to match employee contributions up to a certain percentage. Employers won’t often match 100% of your contributions dollar for dollar, but they can contribute a significant amount of money. Most employers partially or fully match employee contributions up to 6% of the employee’s salary. Let’s see what that looks like:
- Partial match example: If you match 50% of an employee’s contributions up to 6% of their salary, and they make $50,000, you’re offering to contribute $3,000, provided the employee contributes $6,000 (or 12% of their salary).
- Full match example: If you match 100% of an employee’s contributions up to 6% of their salary, and they make $50,000, you’re offering to contribute $3,000, provided the employee contributes $3,000.
401(k) matching and profit-sharing programs are two of the most valuable benefits options you can offer employees who are focused on saving for their retirement.
What Matched 401(k)s Mean for Employees Claiming Tax Deductions
First, let’s break down the two types of employer-based retirement plans: traditional and Roth. With a traditional plan, your contributions are deducted from that year’s taxable income. The funds grow tax-free and are subject to taxes only when you withdraw. Roth plans are the opposite: contributions are taxed coming in, but they aren’t taxed when you withdraw. Both plans allow employees to make withdrawals from their accounts once they retire, and this nest egg helps ensure employees have a high quality of life after retirement.
Here’s an example. Let’s say your salary this year is $90,000, and you contribute $10,000 to your 401(k).
- If you contribute to a traditional 401(k), your taxable income for this year is just $80,000.
- If you contribute to a Roth 401(k), your taxable income for this year is still $90,000.
Now, let’s say that you’re retired, and you withdraw $60,000 from your 401(k).
- If you withdraw from a traditional 401(k), your taxable income is $60,000.
- If you withdraw from a Roth 401(k), your taxable income is $0 (because you’ve already paid taxes on contributions into the account).
Generally, if your current income is higher than what you’ll withdraw annually in retirement, you’re better off with a traditional 401(k) – the most common option. However, if your salary places you in a lower tax bracket than you think you’ll be as a retiree (more common for younger people just starting out in their careers), a Roth 401(k) is preferable.
Is a 401(k) Match Taxable?
Whether you have a Roth or traditional 401(k), though, employer contributions are taxed when you withdraw. That’s because even if you are putting your contributions into a post-tax (Roth) 401(k), all employer matches are contributions to a traditional 401(k).
If you have a traditional 401(k), then you and your employer’s contributions will go into the same account, all of which will be taxed when you withdraw. If you have a Roth 401(k), employer contributions will go into a separate traditional account. Your own Roth 401(k) contributions won’t be taxed when you withdraw, but your matched traditional 401(k) contributions will.
Can Companies Deduct 401(k) Matching Contributions from Corporate Taxes?
Employers aren’t required to make matching contributions or even offer 401(k)s or other retirement benefits in the first place. But they give companies a way to incentivize their employees and offer significant tax breaks. Employers can receive tax benefits for contributing to 401(k) plans too — the tax code wants to encourage saving for retirement, so employers are offered tax incentives to contribute in order to trigger a 401(k) tax deduction, as well as to offset the cost of setting up retirement plans.
Credits for Setting Up Retirement Plans
If you’re a small business and want to implement a retirement plan, you may be eligible for the Credit for Small Employer Pension Plan Startup Costs. Your business might be eligible if it:
- Has 100 or fewer employees who were paid at least $5,000 in the preceding year,
- Has at least one plan participant who is a non-highly compensated employee, and
- Hasn’t offered a retirement plan to the same employees in the past three years
A highly compensated employee is any individual who owns over 5% of the business, earns more than $120,000, and is in the top 20% of the company’s earners. ERISA requires companies to have annual nondiscrimination tests to ensure 401(k) plans don’t unfairly benefit these highly compensated individuals.
Qualifying businesses can receive a credit for up to 50% of startup costs, up to $5,000 a year for three years (for a total of $15,000). The credit can be used to offset expenses needed to set up, administer, and educate employees about the plan. (Note: You aren’t allowed to claim the credit and deduct those same expenses.)
Deductions for Ongoing Contributions
One common question for employer contributions is, “Is an employer 401(k) match taxable?” Like we discussed earlier, account owners will pay taxes based on when they withdraw their money. However, for the employer, the answer is different. Every dollar a company contributes to employees’ 401(k) plans is tax-deductible, providing ongoing tax benefits to companies. In short, the answer to the question “Can an employer deduct matched contributions to retirement plans?” is a resounding “yes.” Even some of the administrative fees of managing a 401(k) plan can be tax-deductible.
This has some pretty powerful implications for employers debating between matching 401(k) contributions or increasing employees’ wages. If you give an employee a raise or bonus, she’ll pay income and employment taxes on the money, and you’ll also owe Social Security, Medicare, unemployment and other taxes. The average worker faces a 22.4% tax burden, and the average employer an 8.9% tax burden. All told, a $1,000 bonus ends up costing employers an average of $80, while putting only $776 in employees’ pockets.
On the other hand, if you were to offer an additional $1,000 in matched 401(k) contributions, your addition to their retirement funds would grow tax-free until withdrawal. You’ll be able to write off the contribution, and your employees will enjoy preferential tax treatment as their nest eggs grow. Putting extra funds into a matched 401(k) provides tax benefits to both you and your employees.
Offering a 401(k) Does More than Lower Corporate Tax Bills
In addition to tax write-offs for setting up and contributing to retirement plans, offering a 401(k) provides indirect financial benefits. Employers often hear that retirement plans help lower recruiting costs, increase productivity, and cut down on turnover — and the data bears out this claim.
For example, researchers at Boston College found that states which reduced pension benefits had a diminished ability to “maintain a high-quality workforce.” Opinion surveys agree: 41% of small businesses offering a 401(k) cited attracting and retaining workers as a key motivator, according to a survey by Wakefield Research and Capital One ShareBuilder 401(k).
There’s another, more personal benefit to offering retirement plans. Even though you’re an employer, you are also an employee of the company. This means you personally can participate in the 401(k) plan along with everyone else. In fact, the Wakefield survey found that 39% of small business owners cited personal benefits as a reason they offered retirement plans. By helping your employees save for retirement, you’re also building your own nest egg.
Even beyond tax deductions and credits, offering retirement plans makes financial sense for businesses.
Can Small Businesses Afford to Offer 401(k)s?
That same Wakefield Research survey found that 23% of small business owners don’t offer a 401(k) plan because they can’t afford to match contributions, and 29% said they would consider offering one if plan costs fell. Traditionally, offering a 401(k) has been considered expensive for small businesses – but not anymore. It’s no longer necessary to spend thousands of dollars to implement a 401(k) plan.
Related article: How Much Does a 401(k) Cost Employers?
For example, Human Interest’s retirement plans cost just $120 a month plus $4 per employee per month – less than half the cost of your typical 401(k) provider. Our customers pay less than $500 for setup – and eligible companies can get money back with the tax credit we mentioned earlier. We aim to make our plans affordable to employees as well, so employees pay just 0.57% of their account balance, compared to a nationwide average of 1.89%. Most small businesses want to do right by their employees, and we want to make it easy and affordable for them to do so.
Both employers and employees receive tax benefits for contributing to a matched 401(k) plan. Employees can build their nest eggs tax-free, while employers enjoy tax credits and write-offs, lower employee turnover, and a more productive workforce. If you’re a small business, a low-fee retirement program can benefit your employees and your bottom line.
If you’re looking for a great 401(k) for your employees, click here to request more information about Human Interest.
Veteran portfolio manager, expert investor, and former university finance instructor. She has authored 3 money/investing books. Friedberg also owns the financial websites RoboAdvisorPros.com and BarbaraFriedbergPersonalFinance.com.