The Small Business Owner’s Guide to the 401(k)

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Submitted by: Schmersahl Treloar & Co.

As most people know by now, the 401(k) is a popular defined benefit retirement plan that allows employees to defer income taxes on contributions to their own retirement security. The 401(k) allows for both employee and employer contributions (up to certain limits).

Employers must compete for the most productive employees. Increasingly, offering employees access to a robust retirement plan, generally with employer contributions, is necessary to attract talent. The best employees, after all, have options in any industry – even when the economy is weak.

Few small businesses offer traditional defined benefit pension plans anymore, because of the high cost and ongoing funding commitment. But establishing a 401(k) allows even very small businesses to compete with much larger employers — at a fraction of the cost of offering a fully funded defined-benefit pension plan. All you have to do is set it up.

It’s Affordable.

A number of financial services companies have developed 401(k) programs that are surprisingly affordable to set up and maintain, even accounting for employer contributions. Other than your basic setup and administrative fees, ongoing costs are pretty much limited to matching contributions – which you are free to set.

Contribution Limitations for 2020

For 2020 qualified employees may contribute a maximum of $19,500 (up from $19,000 in 2019). Furthermore, workers who are over age 50 can make additional “catch-up” contributions of up to $6,000 (same as 2019).*

One of the advantages of 401(k)s over IRAs is much higher contribution limits – especially when you take income into account. This is because the federal government sharply limits the ability of higher-income Americans to make tax-deductible contributions to IRAs.

Tax Features of 401(k)s

Both employer and employee contributions to 401(k)s grow tax deferred, unless the plan sponsor offers a Roth option, in which case contributions to accounts within the Roth option grow tax-free (though the income used to contribute to a Roth option is taxable.)

Meanwhile, interest and dividends are not taxed at all, nor are capital gains. The money is only taxed upon withdrawal, at which time the IRS will tax distributions as ordinary income (Roth option accounts excepted).

The Internal Revenue Service will charge a 10% penalty on most withdrawals prior to age 59 1/2 (though employees leaving the work force can pull money out without penalty beginning at age 55).

However, 401(k) participants can roll over balances to an IRA without penalty. If the worker pulls money out of the 401(k) prior to age 59 1/2, the law requires plan administrators to withhold 20% of the funds against taxes.

Sole Proprietorships and Mom-and-Pop Shops

In some cases, you may consider the Solo 401(k). These are also called “Individual 401(k) plans” or “One-participant 401(k)s.” These plans are specially designed for the owner-operator of an extremely small business, who have no other employees other than perhaps a family member. They are built to be affordable and realistic, and to maximize your options as a small business owner. For example, there are generally no ‘top hat’ laws to worry about. But you can contribute money out of your own salary, and have the company you own make employer contributions, as well.

With a Solo 401(k), you can contribute up to $19,500 (up from $19,000 in 2019) of your salary to your plan — plus catch-up contributions of up to $6,500 if you qualify (up from $6,000 in 2019). On top of that, the company that you control can contribute up to an additional 25% of your compensation, as defined by the plan.

You can even set up a plan if you are self-employed, though IRS rules require you to calculate how self-employment tax affects the contributions you can make. Plan on calculating allowable contributions based on net self-employment earnings after subtracting your own contributions plus 50% of whatever your self-employment tax is for the year.

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*Note: Highly compensated employees sometimes have their ability to contribute to their own 401(k) accounts limited. This may occur under so-called “Top Hat” rules, if non-management employees are not participating in the plan. This is Congress’s way of getting managers and business owners to encourage workers to participate in the plans to fund their retirements. Top hat rules prevent business owners and managers from using the 401(k) as private playgrounds to contribute money on a tax-advantaged basis. It therefore behooves business owners and managers to get broad participation from rank-and-file employees in their 401(k) plans. The more buy-in you get from the workforce, the more you can benefit as a manager, owner or other highly compensated employee.

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