When a small business offers a 401(k) plan, it’s often a win-win for business owners and employees. A 401(k) plan can help businesses attract and retain talent, incentivize performance, and lower taxes, while helping employees – including the business owner – meet their retirement goals. If you're a business owner, you've probably asked yourself at some point what you and your employees stand to gain by offering a 401(k) plan. The answer is probably a lot. Here are some of the top benefits.
Top 401(k) Benefits for Employees
Saving for retirement is one of the most important things we must do during our working years. After all, nobody can work forever and living expenses don’t stop after you stop earning a paycheck. The following 401(k) benefits can make it convenient and affordable for employees to achieve their retirement savings goal:
- Convenient payroll deduction – According to AARP, Americans are 15 times more likely to save for retirement if they have access to a payroll deduction savings plan like a 401(k) at their job. This finding is hardly surprising when you consider the convenience of payroll deduction. There are no checks to mail. Employee contributions are deducted from each participant’s paycheck automatically based on their salary deferral election – which is usually based on a % of compensation.
- Tax-advantaged savings – A 401(k) plan can permit both pre-tax and after-tax contributions. Each contribution type offers different tax advantages:
- Pre-tax contributions – include traditional (pre-tax) salary deferrals, safe harbor, matching, and profit sharing contributions. These contributions are not taxed when made. Instead, their amount – plus earnings – are tax-deferred until distribution.
- After-tax contributions – Include Roth deferrals and voluntary contributions. These contributions are taxed when made and tax-free when distributed. Earnings on Roth deferrals can also be distributed tax-free when certain conditions are met.
- Higher contribution limits – 401(k) plans offer higher annual contribution limits than IRAs – which includes SIMPLE IRAs. The higher limits can help participants save at faster rate and retire sooner than IRA accountholders.
- Compound interest - Compound interest can be a powerful tool for building wealth. How it works is simple. When savings are invested, they earn interest - or earnings. These earnings then earn their own earnings. Thanks to compound interest, the earnings on 401(k) contributions can “snowball” (grow in dollar amount) dramatically over time – ultimately lowering the out-of-pocket cost of retirement.
- Dollar-Cost Averaging (DCA) – DCA involves the investment of a fixed dollar amount at regular intervals over a long period of time. 401(k) participants employ this strategy – whether they know it or not – by making regular salary deferrals by payroll deduction. These contributions buy a different number of investment shares each payroll. When shares are more expensive, they buy fewer. When they're cheaper, they buy more. DCA makes it easy for 401(k) participants to participate in the long-term gains of an investment.
- Professional investment advice - A recent Aon Hewitt study found professional investment advice increased the median returns of 401(k) participants by 3.32% annually. Fortunately, just about all 401(k) plans today offer one or more of the three basic forms - Target-Date Funds (TDFs), a financial advisor, or “robo” (algorithm-based) advice.
- Lower-priced investments – Mutual fund companies usually make their funds in multiple share classes. While all classes hold the same underlying securities, they can charge very different fees. Often, 401(k) plans use an institutional share class that costs less than the retail classes available to individual investors.
- Tax credits - Low- and moderate-income workers may be eligible for a Saver’s Credit to help offset part of the first $2,000 they contribute to a 401(k) plan.
- Portability – When a worker leaves their employer, they are usually entitled to a distribution of their 401(k) account immediately. They can roll this distribution to a new employer’s 401(k) plan or a personal IRA.
Top 401(k) Benefits for Employers
While 401(k) plans are primarily intended to help employees prepare for retirement, they can also offer compelling employer benefits, including:
- Attracting and retaining talent – Retirement benefits are becoming increasingly important to employees. A recent Accenture study found that two-thirds (68%) of workers said a retirement plan was a critical factor in deciding whether or not to accept a job, while 62% said a plan was a critical factor in staying with a job. In short, a 401(k) plan can be powerful tool for employers to attract and retain employee talent.
- Tax credits - the SECURE Act permits an eligible small business to claim a tax credit for adopting a new 401(k) plan and/or a new automatic enrollment feature:
- Qualified startup costs - Before the SECURE Act, a small business could claim a tax credit equal to 50% of their “qualified startup costs,” up to a $500 limit. Now, the limit is the greater of (1) $500 or (2) the lesser of (a) $250 multiplied by the number of non-Highly Compensated Employees (non-HCEs) eligible for plan participation or (b) $5,000. This credit is available for up to three years.
- Automatic enrollment - Small businesses can earn an additional $500 tax credit by adding an automatic enrollment feature to a new or existing 401(k) plan. The credit is available for each of the first three years the feature is effective.
- Tax deductions – all businesses can claim a tax credit deduction for paying 401(k) plan-related expenses, including:
- Employer contributions – When an employer allocates a safe harbor, matching, and/or profit sharing contribution to their 401(k) plan participants, they can deduct the amount contributed. The deduction is limited to 25% of the total compensation earned by plan participants during the year. Total compensation includes elective deferrals, but deferrals are not counted against the 25% deduction limit. For 2023, the maximum compensation that can be taken into account for each participant is $330,000.
- Administration fees - When 401(k) administration fees are paid by the plan sponsor, plan participants are not the only beneficiary – the owners can deduct the fees as a business expense. This approach can be a win-win for plan participants and business owners – who often pay the lion’s share of administration fees paid from plan assets.
- Incentivizing Performance – A profit sharing contribution can be allocated among 401(k) plan participants using dramatically different formulas. New comparability is the most flexible formula. It allows an employer to allocate multiple contribution rates to different employee groups – or even a different rate to each employee. Most often, employers use this flexibility to allocate larger contribution rates to business owners or other Highly-Compensated Employees (HCEs), but it can also be used to reward employees for high performance.
Maximizing 401(k) Benefits Can Take Some Shopping
Not all 401(k) plans created equal. 401(k) administration services and investments can vary dramatically in terms of quality and price. This variability can make it difficult for business owners to maximize the employee and employer benefits of their 401(k) plan.
To overcome this challenge, I have a simple recommendation for business owners. When shopping for a 401(k) provider, look for three key attributes - low administration fees, cost-efficient investments, and consultative plan design. These features can help employees retire years sooner and a business meet their plan goals at a lower cost.