The basics of 401(k)s for small businesses

What is a 401(k)?

A 401(k) is a savings and investing plan offered by businesses to give employees a tax-deferred way to set aside money for retirement. Employees select a percentage of their salary to be automatically withdrawn from their paychecks and invested in specific funds — typically mutual funds, index funds, or other types of investments.

Because 401(k) contributions are made with pretax dollars, they reduce your employee’s gross income for payroll tax deductions — and how much tax they and you have to pay on those wages. But remember, Uncle Sam will still come calling for his share when they withdraw the funds, but it will usually be at a lower rate.

If your business has fewer than 100 employees, your company may also qualify for a tax credit for up to $500 per year for the first three years just for offering a 401(k) plan. Plus, you can also contribute to your company 401(k) to help build your nest egg.

Are employer contributions required for a 401(k) plan?

No. But 90% of employers match employee contributions. You can choose to match or not, depending on what makes sense for your business. If you do, bear in mind that the most common range of employer matches is somewhere between 3-5% of the employee’s salary, but it varies depending on the plan you choose. Plus, company match contributions are tax-deductible, so it’s a win-win since both of you get a bit more for your money.

If you are curious to see how the payroll deductions will work for your employees, try a 401(k) calculator to check out how the math works out.

Are small businesses required to offer a 401(k)?

No states currently require employers to offer a specific kind of retirement plan, but California, Illinois, and Oregon have established state-mandated programs or requirements for businesses to offer some kind of retirement plan. Ultimately, the goal of these programs and traditional employer-sponsored 401(k)s is to help employees save for their future.

Types of 401(k) plans for small businesses

There are three types of 401(k)s available for small businesses — each with different stipulations attached.

Traditional 401(k)

A traditional 401(k) plan allows employees to set aside a percentage of their salary with pre-tax dollars as a payroll deduction. Under this plan, you have the option to match your employees’ contributions based on their elective deferral —  how much employees choose to contribute. This type of plan is subject to non-discrimination testing known as the ADP (actual deferral percentage) test and the ACP (actual contribution percentage) test.

This testing is run annually to ensure that rank and file employees have the same opportunity to participate in your company’s retirement plan as owners and executives. If lower-income employees participate at lower rates (based on pre-set formulas), the plan will fail and your company will be required to make contributions on behalf of employees or highly-compensated employees will have to take back their contributions.

In 2024, the contribution limit for employee elective deferrals under traditional 401(k) plans is $23,000 annually for employees under 50, and $30,500 for employees 50 and older. This amount is normally adjusted every couple of years as cost-of-living increases. You also have the option to implement a vesting schedule for your contributions.

This means you can reserve the right to forfeit the funds you have contributed to your employees 401(k)s, should they decide to leave the company before a certain period of time.

Safe Harbor 401(k)

A safe harbor 401(k) plan lets you skip out on the nondiscrimination testing, but requires that you make contributions to your employees that are 100% vested. In other words, no matter how long your employees work for your company, they have all the rights to the contributions you have made thus far.

Under this type of plan, you are required to contribute to your employees 401(k)s, either by matching their contributions or through non-elective contributions. While safe harbor plans are not subject to nondiscrimination testing, they do require that the plan satisfies certain notice requirements.

Each employee should receive an annual written notice, which outlines content and timing requirements, as well as the rights and obligations they have under the plan. The contribution limit for this plan is also $23,000 annually for employees under 50 and $30,500 for employees 50 and older, but again, subject to change in the future based on cost-of-living.

Both traditional and safe harbor plans are applicable to companies of any size and can be combined with other retirement plans.

Simple 401(k)

A Simple 401(k) is designed specifically for small businesses. This type of plan is applicable to companies with 100 employees or less, and to employees who have received at least $5,000 in compensation from your company in the previous year. A Simple 401(k) is not subject to nondiscrimination testing, and can’t be combined with any other 401(k) or retirement plan.

The contribution limit for this plan is lower than the others, at $16,000 annually and $19,500 for employees 50 and up, and also requires that your contributions are 100% vested by your employees. You have two options for contributions under this plan — a dollar-for-dollar match up to 3%, or a nonelective contribution of 2% for each eligible employee.

How to get started with a 401(k) for your employees

It’s important to give yourself enough time in advance if you want your plan to take effect by a certain time. While it’s theoretically possible to administer a 401(k) yourself, professional help is highly recommended. Professional providers make it easy for small businesses to offer a 401(k) plan by making sure deadlines are met, handling all the testing and paperwork, dealing with payroll deductions, and managing investments. They also take on some or all of the liability.

And there you have it — now you’re ready to offer your employees one of the most sought after benefits in the labor market today. And don’t forget to add yourself to the plan too!