Attracting and retaining employees is essential for the success of any business. Employees today are looking for a positive work culture, flexible scheduling, opportunities for career and development, as well as competitive compensation and robust benefits packages.
Offering an employer-sponsored retirement plan not only helps employees save for their future, but it also provides tax benefits for businesses. By offering a retirement plan, businesses can qualify for tax deductions on their contributions, as well as potential tax credits for setting up the plan. Additionally, offering a retirement plan can help attract and retain talented employees, which can lead to increased productivity and overall success for the business.
There are two basic aspects to tax savings related to retirement plans:
- Tax savings for making contributions
- Tax savings from deferring tax on earnings
Taxes are one of the most significant expenses you incur each year as a business owner, so it’s worth your time to explore your options to minimize the overall amount of taxes you pay.
Tax Savings for Contributions
Deductible contributions. Retirement Plan Contributions for Employers and Self-Employed Individuals. When employers contribute to qualified retirement plans, they are eligible for a deduction that reduces their taxable income. In the case of a self-employed individual, contributions made for their employees are deductible from their business income. For contributions made to their own accounts, self-employed individuals can deduct the amount as an adjustment to gross income. Although these contributions are not taken as business expenses, they provide a valuable opportunity for self-employed individuals to shelter their profits by saving for retirement.
Tax-Free Contributions for Salary Reduction. An employee's contributions to their 401(k), SIMPLE IRA, or similar plan are not subject to taxation. As of 2023, an employee can contribute up to $22,500 ($30,000 if they’re 50 years or older by year-end). These contributions reduce the taxable compensation for income tax purposes. When it comes to employment taxes, there are no Social Security or Medicare (FICA) taxes on employer contributions, including employer-matching and non-elective contributions to employees' 401(k) and SIMPLE IRA accounts. However, while exempt from income tax withholding, employees' salary reduction contributions are subject to FICA taxes for both the employee and employer.
Tax Deferral: A Strategy for Maximizing Investment Growth
Tax deferral is a powerful tool that allows taxes to be postponed until distributions are made. This approach enhances the account's growth potential by allowing the funds to compound and grow without being reduced annually by taxable account payments.
For instance, an employee who contributes $5,000 annually via a salary reduction contribution and allows it to accumulate for 30 years rather than taking it as taxable income, would save over $28,000 in taxable income during that period ($943/year for 30 years) based on a 22% income tax bracket. Tax deferral is an excellent strategy for maximizing investment growth potential.
It's true that there will be tax implications when taking distributions, but luckily under the required minimum distribution (RMD) rules, distributions aren't required until age 73 or retirement (if later and if the plan permits). In addition, these distributions can be distributed throughout one's lifetime. Many retirees find themselves in lower tax brackets when taking distributions than they were when contributing and earning on their investments. While it's important to note that future tax reform could change tax brackets, it's unlikely that many people will find themselves in higher tax brackets.
Understanding Designated Roth Accounts for Your 401(k) Plan
For those who offer a 401(k) plan, allowing employee contributions to a designated Roth account is an option. These accounts are similar to Roth IRAs, although not entirely the same. Employees make contributions on an after-tax basis (no employer contributions), but distributions can eventually become tax-free. Employers can also match Roth deferrals.
Unlike Roth IRAs, contributions to designated Roth accounts do not have income limitations. This means that individuals with higher incomes can utilize these accounts to establish tax-free income for the future.
Tax Credit for Implementing Retirement Plans
Small business owners frequently cite administrative expenses as a major hurdle in offering retirement plans. However, this issue can be resolved using the tax savings from claiming a federal income tax credit available to small businesses through the SECURE Act. Businesses with 100 or fewer employees who earned a minimum of $5,000 in compensation in the previous year may be eligible for a total of $16,500 in credit over three years ($5,000 per year and an additional $500 per year for implementing auto-enrollment) that can be used to more than offset the administrative setup costs of a workplace retirement plan.
The new SECURE Act 2.0, which was passed in late December 2022, offers an additional credit of up to $1,000 per employee. The employer contribution credit is typically a percentage of the amount contributed by the employer. It is restricted to businesses with 50 or fewer employees, and it is reduced for those with 51 to 100 employees.
It's worth noting that the credit cannot be used by self-employed individuals for their own plans, or for owner-employees who don't have non-highly compensated employees participating in their plans.
Offering a retirement plan can lead to significant tax savings for both employers and employees alike. However, it's important to be aware of potential tax traps that could result in penalties, such as excess contributions, prohibited transactions, early distributions, and excess accumulations. A tax-intelligent financial professional can help you navigate these plan complexities while saving you time and worry.
Overall, offering an employer-sponsored retirement plan can have a positive impact on both employees and the business itself. It's a win-win situation that can lead to increased job satisfaction, tax benefits, and a competitive edge in the marketplace.