What Every Small Business Owner Needs to Know About Startup 401(k) Plans

What is a 401(k) plan?

Introduced in the 1970s, a 401(k) plan is an employer-sponsored plan that allows employees to contribute a portion of their wages to an investment account they can use when they retire.

Any small business with at least one full-time employee (other than the owner) is eligible to set up a startup 401(k) plan. There are two options for this:

• A traditional 401(k) plan is funded with pretax money (gross earnings). Funds are deducted from employees’ paychecks before federal, state and other taxes have been taken out. Taxes are taken out when withdrawals are made.
• With a Roth 401(k) plan, contributions are deducted from employees’ net pay – after taxes have been taken out. Since taxes are taken out when contributions are made, the money is not taxed when withdrawals are made.

How does a 401(k) work?

When enrolled in a 401(k), an employee designates a percentage or dollar amount of their earnings to be withheld from each paycheck and deposited into their retirement account. Deducted funds are sent to a third-party administrator (TPA), which invests the money based on the employee’s wishes. Some employers choose to match employees’ 401(k) contributions to their plans as an incentive for staff to participate in the program.

The money then stays in the retirement account until the employee decides to withdraw their funds. If they do so before the age of 59.5, they are subject to an early-withdrawal penalty. If an employee leaves the employer, they take the money they saved with them. However, if a matching contribution with a vesting schedule is part of the program, they might not be able to take all of the employer contributions when they go. 

A traditional startup 401(k) plan has annual administrative and recordkeeping costs that are typically between $500 and $3,000, depending on the plan features and the number of participating employees.

“In general, a company with fewer than 10 employees will [incur] a cost of around $1,200 to $1,500 per year for plan administration, plus some small investment fees,” said Adam Bergman, president and founder of IRA Financial. “These costs are tax-deductible to the business.”

Benefits of a startup 401(k) plan

There are several benefits for small businesses that make offering employee retirement plans a more attractive option today than in past decades.

Tax breaks

In 2020, the SECURE Act (Setting Every Community Up for Retirement Enhancement) increased tax credits for businesses that set up a 401(k) plan. The act brought a tenfold bump to the tax credits businesses with 100 or fewer employees can claim for qualified setup and administrative costs associated with startup 401(k) plans. The bigger offset – a tax credit of up to $5,000 – makes startup 401(k) expenditures easier to bear.

Under previous laws, the tax credit for the first three years of a startup 401(k) plan was 50% of qualified startup costs, not to exceed $500. Under the SECURE Act, the tax credit limit is the greater of (1) $500 or (2) the lesser of $250 multiplied by the number of non-highly compensated employees (HCEs) eligible for plan participation or $5,000.

Qualified startup costs include the costs to set up and administer the plan and to educate employees about it. For the 2022 plan year, the IRS considers an HCE to be any individual whose compensation is more than $135,000 in 2022.

“The more non-HCEs you have, the higher the tax credit, up to the $5,000 maximum,” said Robert Pyle, owner of Diversified Asset Management. “The credit can be claimed for three years.”

Additional tax breaks make 401(k) plans even more appealing. Businesses can earn an extra $500 credit by adding an automatic contribution feature or arrangement to a new startup 401(k) plan. This lets employers automatically enroll eligible employees in the plan. In order not to participate, employees would have to specifically opt out. A company can take the credit for automatic enrollment each of the first three tax years it uses the feature.

Here’s an example of how the credit would work for a small business that has 20 non-HCE employees and opts for automatic enrollment:

• 20 non-HCEs x $250 = $5,000, the company’s maximum tax credit per year
• Startup costs of new plan: $4,500
• 50% of $4,500 = $2,250
• Auto-enroll plan credit: $500
• Total credit per year: $4,500 – $2,250 – $500 = $1,750
• Cumulative credit for the three years: $1,750 x 4 = $5,250

There is a caveat: Employers cannot set up a second retirement plan to get more tax credits.

“The credit is only available when an employer is establishing a new retirement plan, including 401(k) plans, 403(b) plans, profit-sharing plans, cash balance plans, SIMPLE IRAs and SEP IRAs,” said Colin Exelby, founder and president of Celestial Wealth Management. “If, during the previous three years, the employer offered a retirement plan that covered substantially the same employees as the new plan, the tax credit is not available.”

Lower costs

In the past, most 401(k) plans came with hefty administration fees based on a percentage of assets under management. It’s more common now for plan administrators to be paid a fixed amount per plan participant, keeping costs more manageable. Additionally, there has been an explosion in the number of available 401(k) plans designed specifically for small businesses, making them more affordable.

Online tools

Modern 401(k) providers provide online savings calculators and digital access to plan details, minimizing the physical paperwork and telephone conversations involved in managing 401(k) plans. The simplicity of operating a 401(k) program today compared to years past makes it more feasible for many small companies.

How do I start a 401(k) plan for my employees?

If you’re interested in offering your employees a 401(k) retirement savings plan, follow these steps.

1. Figure out your service provider strategy.

There are three major players in a 401(k) plan strategy: the TPA, the recordkeeper and the investment advisor.

“The TPA designs the plan and handles all plan testing and IRS reporting,” Bergman said. “The primary purpose of a recordkeeper is to keep track of the plan money, and the investment advisor helps the plan trustee [business owner] select investments to offer plan participants. A business owner can use one company that offers a bundled approach or multiple companies – it’s a matter of personal preference.”

2. Decide whether to offer an employer matching contribution.

Employers aren’t required to contribute to employees’ 401(k) accounts. However, many make a matching contribution to encourage employees to participate.

According to Fidelity, in 2021, the average match was 4.6%. So, for example, if an employee decided to make a 5% salary contribution, the employer would add another 4.6%. That would bring the total amount the employee is saving for retirement to 9.6% of their salary.

Employers that offer a matching contribution must also determine whether they want it to have a vesting schedule. A vesting schedule prevents an employee from taking the money and leaving for a new employer after only a short period with the company making the matching contribution.

A vesting schedule might last three years, for instance. Each year of employment, an employee would become 33% vested. That means, if they leave after just one year on the job, they would take all of their contributions to the 401(k), plus 33% of what the employer contributed. After three years, they would be fully vested and eligible to take all of the contributions should they leave for a new job.

However, some companies offer immediate vesting to make their place of employment and 401(k) plans more attractive. In that case, an employee is eligible to take all employer contributions with them regardless of how long they’re with the company.

3. Shop around carefully for a plan provider.

The best 401(k) providers offer these features:

• Transparent pricing: “I cannot stress this enough,” said Alan Schoenberger, principal at Endeavor Financial Planning LLC. “There are many 401(k) providers that try to bundle costs together, which can make it difficult to determine what you are truly paying for the plan.” Do not sign up with a vendor that doesn’t make its fee abundantly clear.
• Simple setup: Look for a plan that offers easy setup options, with limited paperwork and the flexibility to do much of the administrative work online.
• Payroll integration: “A 401(k) plan should have the highest level of integration to and from payroll/paychecks,” said Brian Halbert, owner of Halbert Economics. “This saves time and headaches for small business staff.”
• Compliance support: The provider should ensure your plan’s compliance with IRS regulations and the Employment Retirement Income Security Act of 1974 (ERISA). This law governs minimum requirements for retirement plans.
• Flexibility: Look for a provider that gives you access to a wide assortment of fund options, allowing you to design the right plan for your company.

4. Create your plan documents.

A TPA typically handles this step for the best employee retirement plans. The documentation should include information on when employees are eligible to participate in the startup 401(k) plan, any pertinent details about employer matching and profit sharing, a description of plan distributions, and contact information for the employer, TPA, recordkeeper and investment advisor.

Ensure that this information is correct and readily available to employees. You’ll need it for future reference and, more importantly, to demonstrate your compliance if you face an IRS audit. [Read related article: Getting Audited? How to Handle It Like a Pro]

5. Get the word out.

Depending on your plan, you may need to let eligible employees know that it’s available before it goes into effect – typically 30 days prior to the effective date.

Starting up with a 401(k)

Establishing a 401(k) plan can help business owners attract and retain better talent. By helping employees save for retirement, team members become more invested in their jobs. Many of the costs when establishing a 401(k) plan are tax-deductible, making them even more enticing to business owners. However, it’s vital that employers follow legal guidelines to prevent noncompliance that can lead to penalties and fines. Learn more about small business retirement plans.

Kimberlee Leonard contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.