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What are the tax benefits you can rely on when offering a 401(k) plan?

Posted by Neha De

May 6, 2022    |     3-minute read (591 words)

Salaries. Rent. Office supplies. Utilities. There are several business expenses that can be claimed as tax deductions. But were you aware that your 401(k) plan contributions also offer significant tax benefits? 

Background: A “401(k) Plan is a defined contribution plan where an employee can make contributions from his or her paycheck either before or after-tax, depending on the options offered in the plan. The contributions go into a 401(k) account, with the employee often choosing the investments based on options provided under the plan. In some plans, the employer also makes contributions such as matching the employee’s contributions up to a certain percentage. SIMPLE and safe harbor 401(k) plans have mandatory employer contributions,” according to the IRS.

Read on to find out the various tax credits and deductions you can claim when offering a 401(k) plan to your employees.

Tax credits 

The SECURE ACT (Setting Every Community Up for Retirement Enhancement) Act, a bipartisan, retirement-related bill, was passed at the end of 2019. It allows eligible small businesses to claim a tax credit for taking on a new 401(k) plan and/or a new automatic enrollment feature:

Qualified startup costs – Before the SECURE Act came into force, a small business could claim a tax credit equal to 50% of their qualified startup costs, up to a maximum of US$ 500. 

Now, the limit is the greater of (1) $500 or (2) the lesser of $250 multiplied by the number of nonhighly compensated employees eligible for plan participation or $5,000. This credit is available for up to three years.

The IRS defines a highly compensated employee as “An individual who:

1. Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or

2. For the preceding year, received compensation from the business of more than $125,000 (if the preceding year is 2019, $130,000 if the preceding year is 2020 or 2021 and $135,000 if the preceding is 2022), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.”

Automatic enrollment – Adding an automatic enrollment feature to a 401(k) plan can earn a small business an additional $500 tax credit. The credit is available during the first three years the feature is in effect. 

Tax deductions 

Tax credit deductions are available for all businesses for 401(k)-related expenses, including: 

Employer contributions – Contributions made by employers to their 401(k) plans can be deducted if they include matching, safe harbor and profit sharing contributions. 

The amount of deduction is limited to 25% of the total compensation earned by participants of the plan during the financial year. Total compensation includes elective deferrals; however, deferrals are not counted against the 25% deduction limit.

Administration fees – When the plan sponsor pays the 401(k) administration fees, participants of the plan are not the only beneficiaries – business owners can also deduct the fees as a business expense. 

The bottom line

The employer match in a 401(k) plan is an attractive benefit for recruiting. If a job applicant has multiple offers and where everything else is at par, the 401(k) contribution matching could become a deciding factor in selecting one company over another.

Also, businesses receive tax benefits for contributing to 401(k) accounts. Specifically, their matches can be deducted from their federal corporate income tax returns. They are also often exempt from payroll and state taxes.

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