How to Start a 401(k) Retirement Plan for Your Small Business
Setting up retirement accounts benefits your employees and you
Company-sponsored retirement plans were once out of reach for many small businesses, but recent federal law changes and incentives are designed to encourage you to start a plan for your employees and yourself. They have become widely accepted by larger employers for retirement savings, and the Internal Revenue Service (IRS) estimates that 55 million U.S. workers participate in 401(k)-type plans.
What is a 401(k) Plan?
A 401(k) plan is a type of IRS-approved retirement plan that allows employees to contribute pretax amounts (called salary deferrals) to individual retirement accounts. Employers also can contribute to employee accounts, often by matching employee contributions, up to a certain percentage.
How Can a 401(k) Help My Business?
Setting up and contributing to a retirement plan can benefit your business, you as the owner, and your employees.
Benefits to Your Business
Your employer contributions are a deductible business expense, which reduces your business taxes.
Your business can get tax credits and other incentives for starting a plan. The tax credit is for employers with 100 or fewer employees, and is applied to 50% of your eligible startup costs for a 401(k), up to a maximum of $500 a year. The credit is given for setting up and administering the plan and educating your employees about it.
Beyond that, offering a retirement plan is attractive to current and potential employees, giving you a competitive advantage when hiring and retaining talent.
Benefits to You and Your Employees
Investments in the plan grow tax-free after contributions are made, and no tax is paid on investment gains until employees take out the money. Contributions to the plan can reduce taxable income for the year.
Employees can make contributions through payroll deductions, and move the assets in their plan to another employer’s plan when they change jobs.
What Else Do I Need to Know?
Here is some more important information that you need to know as a business owner when considering starting a 401(k) plan.
A 401(k) plan is considered a qualified plan, under IRS rules. That means it must meet the requirements of the Internal Revenue Code for this type of retirement plan, which include issuing periodic reports about the plan to participants and the IRS.
The 401(k) and some other types of employer-sponsored retirement plans are called “defined contribution plans” because the contributions are defined, but not the benefits, as is the case with traditional pensions. The value of the account changes with the level of contributions and the performance of the person’s investments.
Contributions to deferred retirement plans, including 401(k) plans, are not taxed initially. But the account owner must pay tax on the investment and earnings (dividends and share-price increases) when they are taken out of the plan, at retirement or under specially allowed circumstances.
Who Oversees Retirement Plans?
The IRS qualifies, or approves, plans and regulates them from a taxation standpoint. The U.S. Department of Labor (DOL) oversees employer-sponsored retirement plans, following the Employee Retirement Income Security Act of 1974 (ERISA). They deal with fiduciary responsibilities of plan sponsors, participant rights, and the guarantee of benefits.
Who Can Participate in the Plan?
In general, employees who are aged 21 or over who have completed one year of service can enroll in the plan. You can’t exclude an employee because he or she has reached a specified age.
The IRS sets restrictions to make sure that retirement plans benefit all employees, not just highly compensated employees (HCEs) such as company executives, owners, and high-earning staff members. The IRS defines HCEs as those who:
- Owned more than 5% of the interest in the business the previous year, or
- Received compensation during the preceding year of more than a specific amount ($125,000 for 2019 or $130,000 for 2020 and 2021).
You’ll see restrictions in the plan documents in various places that limit participation by well-compensated employees. For example, employee and company matching contributions for HCEs must be proportional to those for other employees. You can participate in your company’s 401(k) plan as an owner, with some caps on the amount you can contribute each year.
If you have no employees and are the only person in your business, you might be able to qualify for what’s known as a Solo 401(k). It allows a one-owner business (of any type of business legal structure) to contribute to the plan. You may be able to contribute as both an employee and an employer.
Read more from the IRS about one-participant 401(k) plans.
How Do I Create a 401(k) Plan?
Creating a 401(k) plan for a company—even a small one—is a complex process. The following is a basic overview of the steps for getting approval and starting the plan:
- Write a plan with the help of a plan adviser and send it to the IRS for a determination letter (approval).
- Share information with employees as you start the plan, and then each year afterward.
- Find a trustee (investment manager) to help you decide how to invest contributions and manage individual employee accounts.
- Begin making employer contributions, if offered, and allowing employee contributions through your payroll system.
What Features Should I Have in a 401(k)?
Matching Contributions. Your company isn’t required to make contributions to the plan, but you can choose to contribute a percentage of each employee’s pay, you can match the amount each contributes (up to a specified limit), or you can do both. Under a traditional 401(k), you can change the amount the company matches each year.
Automatic Enrollment. One increasingly popular feature of workplace retirement plans is automatic enrollment, as a way to increase employee participation. You can set up an individual plan for each employee, and automatically deduct retirement plan contributions from their paychecks. Each employee can opt out or change the amount over time.
Beginning Jan. 1, 2020, your business can qualify for a new tax credit of up to $500 for setting up a new auto-enrollment account, thanks to the SECURE Act law, which stands for “Setting Every Community Up for Retirement Enhancement.” It put into place numerous provisions intended to strengthen retirement security across the country. This auto-enrollment tax credit for employers is in addition to the startup credit described above, and it’s available for three years.
Vesting. You must include language in your plan document on how employees become vested in the plan, but your business can set the details. Vesting in a retirement plan means ownership. If an employee’s retirement account is vested, it can’t be forfeited if he or she leaves the company. Vesting depends on the type of contribution and the length of an employee’s service with your company:
- An employee’s own contributions are vested at 100% immediately, by law. These amounts can’t be forfeited for any reason.
- Employer contributions for 401(k)s can have a variety of vesting schedules, as determined by your business in your plan document. You can have immediate vesting, 100% vesting after a certain number of years of service, or a vesting schedule that increases the employee’s vested percentage each year.
All employees must be 100%-vested by the time they attain normal retirement age, or when the plan is terminated.
Investment Options. You’ll need to decide how to invest the money in employee accounts and what investment options you want to make available to employees. Find an investment advisor to manage the investments and help you and your employees decide on a menu of allocation options.
Information for Participants
You must make periodic reports to plan participants, including an annual summary plan description and an individual quarterly benefit statement showing each participant’s account status. You must also file an annual information report called a Form 5500 about your plan with the federal government.
TIP: You have some discretion on what you offer employees in a 401(k) plan, but establishing one also has many specific requirements. This IRS article, “A Guide to Common Qualified Plan Requirements,” has more information on minimum conditions and what you need to include in your plan.
Overwhelmed? Here’s Help
Many financial institutions, plan vendors, and other organizations offer IRS pre-approved 401(k) plans, a template that can greatly lessen the administrative burden of establishing and maintaining a 401(k).
IRS. "Retirement Plans Startup Costs Tax Credit." Accessed Nov. 6, 2020.
IRS. "Definitions: Highly Compensated Employee." Accessed Nov. 6, 2020.
IRS. "2021 Limitations Adjusted as Provided in Section 415(d), etc.," Page 1. Accessed Nov. 6, 2020.
IRS. "What Is a Favorable Determination Letter?" Accessed Nov. 6, 2020.
IRS. "Operating a 401(k) Plan: Contributions." Accessed Nov. 6, 2020.
IRS. "Automatic Enrollment Fact Sheet." Accessed Nov. 6, 2020.