Summary/TL;DR
When properly utilized, 401(k) plans can easily save small business owners tens of thousands of dollars in taxes annually, while costing only a few thousand dollars annually in administration costs. In addition to the high contribution limits available to all 401(k) participants through salary deferrals and employer matching, small business owners can also take advantage of profit sharing contributions for additional saving opportunities. Finally, 401(k)s have the additional flexibility of having a cash balance pension integrated with them for even more savings.
Introduction
Without proper guidance, a small business owner will pay more in taxes than they would as an employee earning a salary. With proper guidance, however, they will pay far less. Numerous tools exist for business owners to take advantage of, and perhaps none are as easy, cost effective, and as powerful as Section 401(k) retirement plans.
Today’s post is all about how these plans work and how business owners are uniquely positioned to reap huge tax savings from them.
401(k) Basics
Elective Deferrals
401(k) plans are employer retirement plans that offer business owners and participants a tax-advantaged vehicle for their long-term savings. Plan participants contribute to the 401(k) as a percentage of pay. These are known as elective deferrals. Since elective deferrals are made via payroll deductions, only employees of the company (i.e., not contractors) may participate in the plan. Elective deferrals may be made on either a pre-tax basis, in which case they are deducted from the participant’s taxable income in the present, or on a Roth basis, in which case they are included in taxable income and all growth is received tax-free upon eventual distributions.
The IRS places an annual limit on elective deferrals that a participant can make to a 401(k), which is $23,000 in 2024, plus an additional $7,500 for those aged 50 and older. The elective deferral limit is indexed for inflation.
This high contribution limit already presents small business owners with strong tax-advantages, as their contributions are tax deductible no matter what (unless they elect Roth contributions, which would rarely be advised for those in the 32%+ tax bracket). In 2024, a business owner in the 37% tax bracket could save up to $8,510 (more if they’re older than 50) in taxes every year. And if their spouse is on payroll, they can have their own plan to contribute the maximum amount to as well.
Employer Matching
One of the most sought after characteristics of 401(k) plans are the matching contributions that employers make on behalf of participants. An example of a matching formula might be that the employer will match 100% of the first 3% of elective deferrals, 50% of the next 4%, and 0% on anything above 7%. Employer matching is always done on a pre-tax basis (although this will be changing soon) so employees will not pay taxes despite effectively receiving an increase in pay. Matching contributions are deductible to the employer as well.
Employer matching presents an opportunity for the participant to save more into their plan (and therefore save more taxes, if they are also the employer) than is allowed by the limit placed on their elective deferrals. Using the matching example above, someone saving $23,000 per year in elective deferrals making $150,000 as a salary will have an additional $7,500 contributed to their plan as matching contributions.
Depending on how the plan is designed, employees might not have full ownership of their matching contributions for a period of time (not to exceed 5 years). This can protect the employer by allowing them to reclaim their contributions to participants who leave before a certain period. Participants will always have full ownership in their contributions to the plan.
Investments
Once contributions are made, participants may direct their investments into a variety of pre-selected mutual funds, which may be either active or passive in nature. It is important to reiterate that it is the participant (i.e. NOT the employer) who is responsible for investing their funds.
Age Limits and Penalties
Finally, as tax-advantaged retirement accounts (known as “qualified” plans), participants may not access their funds before their age 59½ without voiding all tax benefits and paying an additional 10% penalty tax on any distributions. Since 401(k)s are only advisable for retirement (long-term) savings, this is rarely an issue.
Upon separation from the company, participants may rollover their 401(k) balance to a new employer’s retirement plan or their personal IRA without triggering taxes or penalties. Finally, any amount of a 401(k) that is pre-tax may be converted to Roth at any age without incurring the 10% penalty tax.
Profit Sharing Contributions
Another limit with 401(k)s that most are unfamiliar with is the limit on overall contributions, which includes elective deferrals, employer matching, and profit-sharing contributions. This amount is $69,000 in 2024 ($76,500 including catch-ups). Profit sharing contributions are exactly what they sound like – additional contributions that may be made out of the company’s “profits”.
There are many differences between employer matching and profit sharing contributions. First, profit sharing is usually discretionary, while employer matching is usually mandatory. Profit sharing contributions must be made to all eligible 401(k) participants, whether they contribute to the plan or not. In practice, there are different formulas that can used to maximize the amounts that may be given to the owners and minimize the amounts required to give to other employees. These additional contributions may be made as late one’s filing deadline for the tax year, unlike elective deferrals. Finally, profit sharing contributions can be made on an after-tax basis and immediately converted to Roth, a very powerful series of transactions known as the “mega-backdoor Roth conversion”, which I’ve written about here.
Profit sharing can turn a regular 401(k) from powerful into almost too-good-to-be-true. In 2024, a business owner in the 37% tax bracket could save up to $25,530 (more if they’re older than 50) in taxes every year. And again, if their spouse is on payroll, they can have their own plan to contribute the maximum amount to as well.
Potential For Cash Balance Pension Add-On
Another advantage of a 401(k) for the small business owner is the potential to integrate a cash balance pension to the 401(k) plan. The details of cash balance pension plans are beyond the scope of today’s post, but for now you can think of it as an account in which additional profit-sharing contributions may be made up to an annual maximum of $275,000!
Cash balance pensions aren’t always the right fit, but when they are, they can be exceptionally powerful.
But What Does It Cost?
One of the most persistent myths about 401(k) plans is that they are expensive to start and administer. There are many providers who specialize in small-mid sized businesses and can have a plan up, running, fully integrated with one’s payroll provider, and receiving contributions for anywhere from $100-500/mo depending on the number of participants. This cost is easily justified by the tax savings potential alone, let alone the long-term growth potential and value it adds to employees of the business.
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