401(k) Tax Credits: More Good Reasons To Offer a 401(k)

It’s no secret that small businesses are less likely to offer a retirement plan than larger companies. According to a survey by Pew Charitable Trusts, just 53% of businesses with 5 to 250 employees provided a retirement plan of any kind. And older companies, as well as those with more employees, were much more likely to sponsor a retirement plan.

Smaller and younger companies – not so much.

There are lots of reasons why small business owners steer clear of the 401(k). They may think a 401(k) plan is too expensive, or too much hassle given the regulations concerning retirement plans. We’ll get to the hassle factor later.

But offering a 401(k) may be less costly than you think. A new breed of 401(k) providers using cloud-based technology are providing low cost plans and advisory services untainted by kickbacks and sales commissions from 401(k) funds.

In addition, there are a number of 401(k) tax credits to encourage employers to start a retirement plan, and to encourage employees to save significant sums each year. Here are four of them.

1. Employers Are Incentivized With a 401(k) Tax Credit

Let’s start from the employer’s perspective.

To encourage small businesses to offer a retirement plan, the SECURE Act permits an eligible small business to claim a tax credit for starting a new 401(k) and/or a new automatic enrollment feature. The credit for starting a new 401(k) can be as much as $5,000, and is available for up to three years.

There are certain requirements to be eligible for this credit. For example, the business may have no more than 100 employees and must not have had a retirement plan in place in the prior three years.

There’s a form specific to this tax credit. That’s Form 8881, “Credit for Small Employer Pension Plan Startup Costs.”

It gets better - small businesses can earn an additional $500 tax credit simply by implementing an automatic enrollment feature. This credit is available for each of the first three years the automatic enrollment feature is effective.

When combined, these credits can total up to $5,500 per year. That's $16,500 for 3 years.

2. Employer 401(k) Contributions Are Tax Deductible

While company matching contributions are common, they are not required.

Company contributions are tax deductible subject to certain limits. This includes both matching and non-elective contributions. If you think a 401(k) will help your company attract top talent, these tax deductions effectively subsidize your recruiting efforts.    

3. Personal Tax Benefits of Participating in a 401(k)

Just as IRS rules encourage employers to open and contribute to a 401(k), the tax laws encourage participants (including owners!) to contribute as well. The two primary benefits of contributing to a 401(k) are salary reduction and tax deferred investment earnings.

Let’s take salary reduction first. When you or your employees contribute to the company 401(k) you are diverting pre-tax dollars to your retirement account. Because these dollars never make it to your paycheck, your 401(k) contribution reduces your taxable income. If your salary is $60,000 and your 401(k) contributions total $5,000, then your taxable income is $55,000 rather than $60,000.

Given that the 2018 maximum employee contribution is $18,500, 401(k) participants can reduce their taxable income by more than $50,000 over three years.

Another big advantage of investing in the company 401(k) is the ability to compound returns tax free. That means all fund distributions, interest earned, and capital gains can be 100% reinvested. Compare that to a taxable brokerage account where you get a 1099 reporting the earnings generated in your account. Once taxes are paid on those distributions, interest and capital gains, less money will be available for reinvestment.

The ability to avoid taxes on investment earnings can make a big difference over the years. Take a look at the table below that compares two $1,000 investments, each made at the beginning of the year. Let’s assume Account A is a taxable account that earns 6% each year for 20 years. Let’s also assume that 6% represents interest, distributions, and capital gains that are taxed at an average rate of 25% each year. After the taxes are paid, the remainder is reinvested to earn another 6% the following year. By the end of Year 20, Account A will have a value of $2,412.

Now let’s look at Account B which begins the period with the same $1,000 and also earns a 6% return. But because the distributions, interest, and capital gains incur no tax, 100% of those earnings are reinvested each year. By the end of the 20-year period, this account is worth $3,207, or 33% more:

1) You are saving a certain amount on a regular basis rather than putting away whatever might be left at the end of the pay period.

2) You are dollar cost averaging. That means when the market is lower, you are buying more shares for the same dollar amount.

3) You are investing automatically so you are not tempted to time the market.

While shifting asset allocations as you approach retirement makes good investment sense, trying to guess the direction of stocks and bonds? Not so much.

4. A Lesser Known 401(k) Tax Credit – the Saver’s Tax Credit

There is another tax benefit for 401(k) participants that isn’t talked about much. It’s called the Saver’s Tax Credit. This IRS incentive is designed to encourage moderate and low income employees to save for retirement.

And unlike the employer 401(k) tax credit for start-up plans, this credit is available every year the participant qualifies. Here’s how it works:

Participants at certain income levels can claim a 401(k) tax credit for up to 50% of the first $2,000 contributed to the plan. So the maximum credit is $1,000, or $2,000 for a married couple. For some participants the credit can reduce their taxes owed to zero. At higher income levels the 401(k) tax credit is reduced to 20%, and finally 10%, of the first $2,000 contributed. This results in a maximum credit of $400 and $200 at those higher income levels.

The maximum income allowed to receive any portion of the Saver’s Credit in 2018 is $63,000 for a married couple filing jointly, $47,250 for head of household and $31,500 for all other taxpayers. The table below shows the maximum adjusted gross income allowed to receive the full 50% Saver’s Tax Credit in 2018:

Are You Thinking About Adding a 401(k)?

The tax code clearly encourages companies to open a 401(k) and make contributions, and it provides tax incentives for participants to build their retirement nest eggs.

But many business owners are worried that offering a 401(k) will consume too many company resources. This is the hassle factor we mentioned earlier. We are proud to say that at ForUsAll we have radically simplified the 401(k) and designed it for small business. We have removed the burdens associated with running a traditional 401(k), and we handle the day to day operations ourselves. And because we use technology to automate many of the tasks associated with a 401(k), we can keep costs low. Meanwhile, good plan design and automatic features can help get your employees enrolled and contributing to your new plan.

Talk to us today to learn how your company can sponsor a low cost, low hassle 401(k). Afterwards, if you think you and your employees will be on your way to building sizable retirement nest eggs – well, that’s a great deduction.  

Note: this post is not intended as tax advice. Please check with your tax accountant for details on tax savings or credits available.