A 401(k) may significantly reduce an employer’s federal income tax thanks to available tax deductions and tax credits.
Plans that offer an employer matching or non-elective contribution may be eligible for additional tax deductions.
Small businesses may also benefit from tax credits that help cover the costs of starting up a new 401(k) plan.
Does a 401(k) reduce employer taxes?
An employer-sponsored retirement plan comes with several tax advantages, including the opportunity to take advantage of tax credits for small businesses starting up a 401(k), and for plans that offer an employer matching or non-elective contribution.
In this context, a 401(k) can significantly reduce an employer’s federal tax liability if the employer chooses to take advantage of the many tax deductions and tax credits available to small businesses with a 401(k) plan. Many of these tax advantages are a result of SECURE Act 2.0, which was recently enacted in December 2022.
What are the tax advantages of an employer-sponsored retirement plan?
According to the IRS, for defined contribution plans (such as a 401(k), profit-sharing plan, or money purchase pension plan), employers can deduct up to 25% of the compensation earned during the year from eligible employees participating in the plan, if they provide the amount as an employer contribution to the plan.
Aside from the tax deductions, an employer match can be an effective benefit for employees as well. Every time a contribution is made to a 401(k) using pre-tax dollars, taxable income for the current tax year decreases.
Lastly, any pre-tax deferrals—the amount employees contribute to their 401(k) plans—and all employer contributions, including any gains, aren’t taxed until an employee makes a withdrawal from their retirement plan account.
Note that if you are a participant who is above the Roth IRA AGI limitation, or if you expect to be at a higher tax bracket near or during retirement, a Roth IRA may be a better alternative.
401(k) tax credits
The original SECURE Act created several new tax benefits for small businesses starting a retirement plan. For example, the original bill added a startup tax credit (more on this below) and an automatic enrollment credit, which provides employers with a $500 tax credit for three consecutive years a plan has an auto-enroll feature.
SECURE 2.0, which was passed in December 2022, expands on most of these incentives. The following are the most relevant 401(k) tax credits for employers.
1. Doubles tax credits for new plans
For small businesses with no more than 50 employees, SECURE Act 2.0 increases the existing tax credit to cover 100% of plan start-up costs up to $5,000 per year for the first three years. This could mean a total of $15,000 in tax credit savings.
Medium-sized businesses with 51 to 100 employees are still subject to original SECURE Act tax credits which cover up to 50% of administrative costs, capped annually at $5,000 per employer for three years.
Keep in mind that there are additional limitations to this credit. The credit is 50% of your eligible startup costs, up to the greater of $500 or the lesser of $250 multiplied by the number of NHCEs who are eligible to participate in the plan, or $5,000.
2. Adds new credits for employer contributions
SECURE 2.0 also added new tax credit for small businesses with no more than 50 employees based on a percentage of employer contributions. Employers can receive a tax credit of up to $1,000 for each employee earning $100,000 or less in the prior year. Businesses with 51 to 100 employees also qualify for this credit, but the amount is phased out by A percentage of 2% points for each employee for the preceding taxable year in excess of 50 employees.
For all employers taking advantage of the credit, the amount phases out based upon the number of years the plan has been in existence:
100% in the first and second years
75% in the third year
50% in the fourth year
25% in the fifth year.
To visualize how much an employer can save with these new and existing tax credits, let’s assume a small business with 45 employees starts a new 401(k) plan with auto-enrollment in 2023. The plan costs $5,000 to start and set up for the first three years. 30 employees make less than $100,000 annually and the small business makes a $1,000 non-elective contribution for each employee over the course of four years. The small business should have earned roughly $117,000 in tax credits from 2023 to 2027.
|Auto-enrollment tax credit||$500||$500||$500||N/A||N/A|
|Employer contribution credit||$30,000||$30,000||$22,500||$15,000||$7,500|
|Set-up and plan administration credit||$5,000||$5,000||$5,000||N/A||N/A|
|Annual tax credit total||$35,500||$35,500||$23,500||$15,000||$7,500|
Total Tax Credits, 2023 - 2027: $117,000
Differences between tax deductions and tax credits for businesses
As a refresher:
Tax deductions lower your taxable income
Tax credits reduce your tax bill by the tax credit amount
For example, if you spent exactly $5,000 on starting a new retirement plan, when netted with the SECURE 2.0 startup tax credit, your startup costs would be equal to zero. Keep in mind that the retirement plan startup tax credits are nonrefundable.
A tax deduction, on the other hand, can reduce your total tax liability. For example, if your small business owes $50,000 in taxes and you use a small business tax deduction of $1,000, your taxable income is now lowered to $49,000, which doesn’t change your tax rate.
Other benefits of a 401(k) plan for employers
A 401(k) can be a key reason why talent will choose to work at one company over another. In fact, according to a 2022 survey commissioned by Human Interest and OnePoll, 2,000 Americans stated that a retirement plan is the second most popular benefit after health insurance. We also found in a separate analysis that a 401(k) may lead to lower turnover rates for small businesses.
Tax advantages for employees
There are several tax advantages for employees with a 401(k) plan as well. As stated above, employees who contribute pre-tax dollars to their 401(k) plan can lower their tax bill for the year since it lowers their taxable income. This can work to an employee’s advantage over time, because once they reach retirement age (and are ready to withdraw from their retirement savings) they will not have to pay as many taxes because they will presumably be in a lower tax bracket.
Interested in discussing the tax benefits of adding a retirement plan at your business? Want to learn about how a 401(k) can create a competitive advantage in recruiting and retaining employees? Talk to us today.
Article ByThe Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.