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Should You Offer a 401(k) Plan – and to Whom?

Julie Ritzer Ross
Julie Ritzer Ross

An employer-sponsored 401(k) retirement plan can have many benefits for both your employees and your business.

  • Offering a 401(k) plan can help small businesses meet increasing employee expectations and retain top talent.
  • A 401(k) plan yields companies significant tax breaks and deductions.
  • Businesses and employees alike benefit from optional employer contributions to workers' 401(k) accounts.
  • This article is for business owners who want to know why they should offer a 401(k) plan with matching contributions and who may qualify for it.

If you're like many small business owners, you've probably asked yourself whether you should offer a 401(k) as part of your employee benefits package. You've probably also asked yourself what you and your business stand to gain from such a move and which employees will benefit from it. The answer is that providing a 401(k) retirement savings plan offers benefits for both employers and employees.

"Any business can set up a 401(k) – a salary deferral plan to which employees can contribute part of their salary and have it not count as income on their W-2," said Christian Brim, CEO at Core Wealth Management. "And oftentimes, businesses with fewer employees benefit most from them."

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What benefits do employers get from offering a 401(k) plan?

A 401(k) plan brings multiple benefits to employers:

Competitive ability to recruit and retain talent 

Retirement benefits are increasingly important to employees. According to a study by Accenture, 68% of workers worldwide ask during the job application process whether a company has a retirement plan like a 401(k), and 62% seriously consider the availability of such a plan when deciding whether to accept or remain in a job.

"There can also be big financial benefits from a 401(k) in helping to retain and attract top talent and the associated cost savings and productivity gains," said Stuart Robertson, CEO of ShareBuilder 401k.

According to Robertson, research shows that replacing an employee costs 29% to 46% of an employee's annual salary, depending on whether that employee is in a managerial position.

"It's estimated that an employee who earns $50,000 a year can cost $14,500 on the low end to replace," he said. "A 401(k) plan is a small price to pay, not only for retirement but also for building and keeping a great team."

Brian Halbert, founder of Halbert Capital Strategies, said his business clients have reported significant increases in worker loyalty and productivity when they added a 401(k) plan to their employee benefits packages.

"The single largest benefit coming from a 401(k) is financially wise employees that have a zeal for working hard for their company," Halbert said. "Oftentimes, we see the ROI in productivity and loyalty."

Lower tax liability

Business owners with employees can contribute a hefty portion of their own salary to their personal 401(k) account (the one associated with the plan they offer to workers), possibly putting them in a lower tax bracket. In 2020, that sum is up to $19,500 tax-deferred for employers under age 50 and up to $26,000 for employers age 50 or over. [Need an employee retirement plan for your business? Check out our recommendations for the best employee retirement plan providers.]

Business tax credits

The new SECURE Act (Setting Every Community Up for Retirement Enhancement) increases tax credits for businesses setting up a first-time 401(k) plan. The act increased by tenfold the tax credit companies with one to 100 employees can claim for qualified setup and administrative costs associated with startup 401(k) plans.

Before the SECURE Act, the tax credit for the first three years of an employee 401(k) plan was 50% of qualified startup costs, not to exceed $500. Those costs included – and still include – the cost to set up and administer the plan and to educate employees about it.

Under the act, small businesses get a 401(k) startup credit whose limit is either the greater of $500 or the lesser of $250 multiplied by the number of non-highly compensated employees eligible for plan participation, up to $5,000, according to Alan Schoenberger, principal at Endeavor Financial Planning LLC.

Robert Pyle, owner of Diversified Asset Management, said the IRS defines a highly compensated employee as one whose salary was more than $125,000 in 2019 and more than $130,000 in 2020. Pyle said the more HCEs a business has, the higher the tax credit. The maximum tax credit, which can be claimed for three years, is $5,000.

Adding an automatic contribution feature to a new or existing 401(k) plan yields another tax break – $500 for each of the first three years in which the feature is available. According to the IRS, this feature – which is also known as automatic enrollment or auto-enroll – lets employers automatically enroll eligible employees in the plan, unless the employee affirmatively elects not to participate in it.

"'Enroll' means that the employer contributes part of the employee's wages to the retirement plan on the employee's behalf," stated the IRS in a FAQs bulletin.  

Business tax deductions

Many employers make matching contributions to employees' 401(k) accounts. These contributions may qualify as ordinary business expenses, in which case they are tax deductible up to the annual corporate deduction limit on all employer contributions (25% of covered payroll). Profit-sharing contributions to employees' 401(k) accounts are also deductible, further reducing the tax liability for small businesses.

Key takeaway: Offering a 401(k) plan increases businesses' potential to recruit employees and keep them in the fold, as well as to see higher worker productivity and financial savings from reduced turnover. Sponsoring a 401(k) also paves the way for business owners to reduce their personal tax liability, enjoy newly available business tax credits, and boost their business tax deductions.

Which employees can an employer exclude from a 401(k) plan?

Any individual who is at least 21 years old and works more than 500 hours per year over a three-year period qualifies for a 401(k) plan if their employer offers one.

"As a general rule, the IRS does not consider the class exclusion of part-time, seasonal or irregular workers to be fair," Jordan Parker, financial advisor turned finance blogger, told Business News Daily.

Before the SECURE Act became law, employers could exclude part-time employees working fewer than 1,000 hours per year from their 401(k) plans. They could also require a waiting period of up to one year before an individual became eligible to participate in that plan.

Under the SECURE Act, however, long-term part-time employees who work at least 500 hours in three consecutive years and are 21 or older must be allowed to participate in an employer's 401(k) plan. This means that part-time employees who were previously not allowed to participate (because they hadn't finished a full year of service for the company in question) are now eligible for the 401(k) plan.

The SECURE Act also mandates that 401(k) plans have dual eligibility requirements for part-time employees. Under this umbrella, an employee is eligible for an employer's 401(k) plan if they are at least 21 years old and either work 1,000 hours for the company within a single year or put in 500 hours of service at that company in each of three consecutive years.

The new rule is generally effective for plan years beginning after Dec. 31, 2020, attorneys Patricia Martin and Molly Callender Hobbs wrote in a blog post for Husch Blackwell. "While service during plan years beginning prior to 2021 is not required to be taken into account for eligibility purposes, it is not clear when a plan must begin counting service for vesting purposes."

Consequently, the attorneys said, companies should track part-time employees' hours going forward and amend existing calendar-year 401(k) plans by Dec. 31, 2022.

Key takeaway: Under the new SECURE Act, part-time employees cannot be excluded from a company's 401(k) plan if they've worked at that business for least 500 hours during each of three consecutive years or for 1,000 hours in one year. Companies will need to amend their plans to reflect the changes by the end of 2022.

Are businesses required to match employees' contributions to a 401(k), and what is the standard match?

While businesses aren't required to offer a contribution match, it's still a good idea. Robertson said matching contributions generate goodwill and, since they are deductible, drive down a business's tax liability.

If you want to offer a matching program but are afraid some employees will just take the money and run, consider a vesting schedule. With a vesting schedule, employees can't take the employer's contributions until they have participated in the retirement plan for a certain length of time.

For example, employer matching contributions might not fully vest for three years. If an employee leaves for another job before those three years are up, they aren't entitled to all of the contributions the employer has made on their behalf. They do get to take all of the money they have personally contributed with them, of course. [Read related article: Employee Retirement Plans: A Buyer's Guide]

Some companies opt for profit-sharing contributions to employees' 401(k) accounts when business is good. As mentioned above, these contributions are also tax deductible.

"The typical 401(k) match is called a safe harbor nonelective match of 3% of [the employee's] salary," Pyle said. "This means the employees get 3%, whether or not they participate in their employer's 401(k) plan. Other match types are 100% on the first 3% of salary deferred and 50% on the next 2% of salary deferred."

Key takeaway: Businesses aren't required to make matching contributions to employees' 401(k) plans, but these contributions may increase employee loyalty. They're also deductible, lowering businesses' tax liabilities.

Image Credit: fizkes / Getty Images
Julie Ritzer Ross
Julie Ritzer Ross
Business News Daily Contributing Writer
Julie Ritzer Ross is an award-winning writer and editor with 40 years of experience covering a variety of industries, including retail, hospitality, professional services, payments, healthcare and business travel. She has written about B2B-focused topics such as recruiting and hiring, paid time off, employee benefits and business credit.