Small business owners often struggle to attract and retain top talent. One way to boost employee satisfaction and loyalty is by offering a 401(k) retirement plan. Not only does this benefit your business, but it also shows you’re committed to your employees' long-term financial security.

In a job market where skilled workers have lots of options, a strong retirement plan can help set your business apart. Employees are more likely to stay with an employer who invests in their future.

Also, when employees feel secure about their retirement savings, they experience less financial stress, allowing them to focus more on their work.

This article will guide you through how to set up a 401(k) plan for small business, covering the types available and how to choose the best option for your needs.

What Is a 401(k)?

A 401(k) plan is an employer-sponsored retirement savings account that allows employees to allocate a portion of their pre-tax salary toward retirement investments.

Named after Section 401(k) of the U.S. Internal Revenue Code, these plans encourage long-term savings by offering tax advantages and, in many cases, employer-matching contributions.

Differences Between 401(k) Plans and Traditional Pension Plans

Traditional pension plans, also known as defined benefit plans, provide retirees with a predetermined monthly payment based on salary history and years of service.

401(k) plans, on the other hand, are defined contribution plans where the retirement benefit depends on the amount contributed and the investment performance of those contributions.

The main difference lies in the responsibility for investment risk:

• Pension Plans: Employers bear the investment risk and are obligated to provide specified retirement benefits, regardless of investment performance. 
• 401(k) Plans: Employees assume the investment risk, with retirement outcomes contingent on individual contributions and investment choices.

In addition, pension plans are becoming less common in the private sector, with many employers favoring 401(k) plans due to their cost predictability and reduced financial liability.

Tax Advantages of a 401(k) Plan

Participating in a 401(k) plan offers several tax benefits:

Pre-Tax Contributions

Contributions are made before federal income taxes are applied, thereby lowering taxable income for the contribution year. For example, contributing $7,500 to a 401(k) reduces taxable income by the same amount. 

Tax-Deferred Growth

Investment earnings within a traditional 401(k) grow tax-deferred, meaning taxes on dividends and capital gains are postponed until funds are withdrawn during retirement.

Roth 401(k) Option

Some employers offer a Roth 401(k) feature, allowing employees to make after-tax contributions. While these contributions don't reduce current taxable income, qualified withdrawals, including earnings, are tax-free in retirement. 

Note that early withdrawals from a 401(k) plan, especially before age 59½, may incur taxes and penalties, signifying the plan's intent as a long-term retirement savings vehicle.

How a 401(k) Plan Works

Here’s a detailed breakdown of how a 401(k) plan works, including employer contributions, vesting schedules, withdrawal rules, and IRS contribution limits for small businesses.

Employee Contributions

Employees can contribute to their 401(k) plans through pre-tax (traditional) contributions and Roth (after-tax) contributions.

Pre-tax contributions are deducted from the employee's salary before taxes, thereby reducing taxable income for the year. Taxes on these contributions and their earnings are deferred until retirement, at which point withdrawals are taxed as ordinary income.

Introduced to provide tax diversification, Roth 401(k) contributions are made with after-tax dollars. While there's no immediate tax benefit, the contributions and their earnings can be withdrawn tax-free in retirement, provided certain conditions are met.

Choosing between pre-tax and Roth contributions depends on individual financial situations and anticipated tax brackets in retirement.

Younger workers, expecting to be in higher tax brackets later, may benefit from Roth contributions, while those currently in higher brackets might prefer the immediate tax relief of pre-tax contributions. 

Employer Contributions

Employers can enhance 401(k) plans by contributing to employee accounts, mainly through matching contributions and profit-sharing.

In matching contributions, employers match a portion of the employee's contributions, commonly up to a certain percentage of the employee's salary.

For example, an employer might match 50% of employee contributions up to 6% of their salary. This approach encourages employee participation and boosts retirement savings.

On the other hand, in profit-sharing contributions, employers contribute a portion of the company's profits to employee 401(k) accounts.

Unlike matching, profit-sharing doesn't require employee contributions and can vary based on the company's profitability. This method can motivate employees by linking their retirement benefits to the company's success.

Both methods offer tax advantages to employers and can improve employee retention and satisfaction.

Vesting Schedules and Withdrawal Rules

Vesting determines the percentage of employer contributions an employee owns over time. Common vesting schedules include:

• Immediate Vesting: Employees have 100% ownership of employer contributions.
• Cliff Vesting: Employees become fully vested after a specific period, such as three years.
• Graded Vesting: Ownership increases gradually over time, for example, 20% per year over five years.

Employees are always 100% vested in their contributions.

Withdrawals from a 401(k) are generally permitted after age 59½ without penalties. Early withdrawals may incur a 10% penalty in addition to regular income tax, though exceptions exist, such as for certain hardships.

IRS Contribution Limits for Small Business 401(k) Plans

The IRS sets annual contribution limits for 401(k) plans, which are adjusted periodically. For 2025: 

• Employee Elective Deferrals: Employees can contribute up to $23,500.
• Catch-Up Contributions: Individuals aged 50 and over can make additional catch-up contributions of up to $7,500, bringing their total potential contribution to $31,000. 
• Total Contribution Limit: The combined total of employee and employer contributions cannot exceed $70,000 or 100% of the employee's compensation, whichever is less. 

These limits ensure small business employees have substantial opportunities to save for retirement.

Types of 401(k) Plans for Small Business Owners

Choosing the right 401(k) plan is important for small business owners who want to provide retirement benefits to their employees while optimizing tax advantages. The various types of 401(k) plans include:

Traditional 401(k) Plan

A Traditional 401(k) plan allows employees to contribute a portion of their pre-tax salary to individual retirement accounts, with potential employer-matching contributions.

This plan offers flexibility in terms of contribution limits and investment options, thereby making it a popular choice among businesses of different sizes.

Pros

• Employers have discretion over contribution amounts and vesting schedules.
• Offering a retirement plan can enhance employee satisfaction and retention.

Cons

• Requires adherence to annual nondiscrimination testing to ensure benefits are equitable across employees.
• Administrative and compliance costs can be higher compared to other retirement plan options.

Safe Harbor 401(k) Plan

A Safe Harbor 401(k) plan is designed to automatically pass the IRS's nondiscrimination tests by mandating employer contributions that are fully vested immediately. This simplifies compliance and ensures benefits are distributed fairly among employees. 

Pros

• By meeting Safe Harbor requirements, businesses avoid complex annual testing.
• Mandatory employer contributions can make the plan more appealing to employees. 

Cons

• Employers must make either matching or non-elective contributions, which can be a financial commitment. 
• Limited ability to adjust contribution levels compared to Traditional 401(k) plans.

Solo 401(k) Plan

Also known as a One-Participant 401(k) plan, the Solo 401(k) is designed for self-employed individuals or business owners with no employees, other than a spouse. It allows contributions both as an employee and employer, enabling higher savings potential.

For 2025, the maximum contribution is $70,000 for individuals under 50, combining employee and employer contributions.

Tax Advantages and Flexibility

• Tax Benefits: Contributions can be made on a pre-tax basis, reducing taxable income, or as Roth contributions, allowing for tax-free withdrawals in retirement.
• Loan Options: Some Solo 401(k) plans permit loans, providing financial flexibility.

Steps for Setting Up a 401(k) Plan for Small Businesses

Highlighted below are steps for setting up a 401(k) plan for your small business:

Determine Business Needs and Goals

Start by assessing the demographics and retirement goals of your workforce. Understanding their interest in a 401(k) plan will help you tailor the plan features to encourage maximum participation.

Also, decide on the level of financial commitment your business can sustain. Employer contributions can be structured as:

• Matching Contributions: The employer matches a percentage of the employee's contributions.
• Non-Elective Contributions: The employer contributes a fixed percentage of each eligible employee's compensation, regardless of employee contributions.
• Profit-Sharing Contributions: Contributions are made based on the company's profitability.

Choose the Right 401(k) Plan Type

Evaluate different plan options to determine the best fit for your business:

• Traditional 401(k): Offers flexibility in contributions and allows for vesting schedules but requires annual nondiscrimination testing to ensure fairness.
• Safe Harbor 401(k): Mandates employer contributions and immediate vesting, eliminating the need for certain compliance tests.
• SIMPLE 401(k): Designed for businesses with 100 or fewer employees. It has less administrative burden but lower contribution limits.

Consider administrative responsibilities, costs, and tax implications when selecting a plan.

Select a Plan Provider or Administrator

A reliable provider is important for effective plan management. Consider:

• Fees: Understand all associated costs, including setup, administrative, and investment fees.
• Investment Options: Ensure a diverse range of investment choices to meet various employee risk tolerances.
• Customer Support: Access to knowledgeable support can assist in addressing plan-related queries and compliance issues.

Research and compare providers to find one that aligns with your business needs and offers transparent pricing.

Establish a Written Plan Document

The IRS requires a formal written document outlining the plan's terms and conditions. This document should detail:

• Eligibility Criteria: Define which employees are eligible to participate.
• Contribution Details: Specify contribution limits and employer contribution formulas.
• Vesting Schedules: Outline the timeline over which employees gain full ownership of employer contributions.
• Distribution Rules: Set parameters for withdrawals, including conditions for loans and hardship distributions.

Consulting with a retirement plan specialist or legal advisor can ensure the document complies with all legal requirements. 

Set Up a Trust for Plan Assets

To safeguard the plan's assets, they must be held in a trust with designated trustees responsible for managing contributions, plan investments, and distributions. This arrangement ensures assets are used solely for the benefit of participants and their beneficiaries. 

Develop a Recordkeeping and Administration System

Implement a system to accurately track:

• Contributions: Monitor employee and employer contributions.
• Earnings and Investments: Keep detailed records of investment performance and allocations.
• Distributions: Document all withdrawals and loans, ensuring compliance with plan rules.

Proper recordkeeping is required for regulatory compliance and simplifies filing required annual reports with government agencies.

Educate Employees About the Plan

Effective communication encourages employee participation. Provide clear instructions on how to enroll and the benefits of participating. Also, offer resources to help employees make informed investment decisions.

Keep participants informed about plan performance and any changes to plan terms. You can also host workshops or provide access to financial advisors for better understanding and engagement.

SIMPLE IRA vs. SEP IRA vs. 401(k): Which Plan Is Ideal for My Small Business?

SIMPLE IRA (Savings Incentive Match Plan for Employees)

It is designed for small businesses with 100 or fewer employees that do not offer any other retirement plans. 

Pros

• Straightforward to establish with minimal paperwork and lower administrative costs compared to 401(k) plans.
• Employees can contribute through salary deferrals, promoting personal investment in retirement.
• Mandatory employer contributions, either matching up to 3% of an employee's compensation or a non-elective 2% contribution for all eligible employees, fostering employee participation. 

Cons

• Employee contribution limits are lower than 401(k) plans, potentially restricting retirement savings.
• Required employer contributions can be a financial strain, especially during low-profit periods.
• Employers cannot maintain another retirement plan alongside a SIMPLE IRA.

SEP IRA (Simplified Employee Pension Plan)

Best for self-employed individuals and small businesses seeking a straightforward retirement plan with higher contribution limits. Only employers contribute to SEP IRAs; employees cannot make salary deferrals.

Employers can decide annually whether to contribute, offering flexibility based on business performance. In addition, employers must contribute the same percentage of salary for all eligible employees, including themselves.

Pros

• It allows contributions up to 25% of compensation, with a maximum limit ($66,000 for 2023), facilitating substantial retirement savings.
• Easy to establish and maintain with minimal administrative responsibilities.
• Employers can adjust contributions based on the company's financial status.

Cons

• Employees cannot contribute, which may limit their engagement in retirement planning.
• Employers must contribute the same percentage to all eligible employees, which could be costly with a larger workforce.
• Employees have immediate ownership of contributions, limiting retention incentives.

401(k) Plans

A 401(k) plan allows employees to defer up to $22,500 annually as of 2023, with those aged 50 and over eligible for an additional $7,500 in catch-up contributions, bringing their total potential deferral to $30,000. Employers can match these contributions, which can enhance employee participation and satisfaction.

For instance, an employer might match 100% of an employee's contributions up to 4% of their compensation.

However, employers must comply with the Employee Retirement Income Security Act (ERISA) regulations and conduct annual nondiscrimination testing to ensure the plan benefits all employees fairly.

Despite these challenges, 401(k) plans offer flexibility, including options like the Roth 401(k), which allows for after-tax contributions and tax-free withdrawals in retirement. These provide valuable tax planning opportunities for participants.

When deciding among a SIMPLE IRA, SEP IRA, or 401(k), consider the following:

• Business Size and Structure: SIMPLE IRAs are suitable for businesses with 100 or fewer employees, SEP IRAs are ideal for self-employed individuals or small businesses with few employees, and 401(k) plans can accommodate businesses of different sizes.
• Administrative Capacity: Evaluate your ability to manage the administrative responsibilities associated with each plan.
• Financial Commitment: Consider the level of contributions you can sustain, especially regarding mandatory contributions in SIMPLE IRAs and uniform contributions in SEP IRAs.
• Employee Needs: Assess the importance of offering a plan that allows employee contributions and the potential impact on recruitment and retention.

Wrapping Up

Implementing a 401(k) plan helps small businesses attract and retain top talent, provide tax advantages, and enhance employee financial security.

However, the complexities of managing such a plan, including compliance, financial oversight, and equity management, can be challenging.

Chore serves as your fractional Chief of Staff, expertly handling HR, compliance, finance, and equity matters so that you can focus on growing your business. By partnering with Chore, you ensure your 401(k) plan is managed efficiently and in full compliance with regulations. Learn more.

FAQs

How much does a 401k plan cost?

Setting up a 401(k) plan for your small business involves:

• Startup Costs: One-time setup fees ranging from $500 to $2,000. 
• Administrative Fees: Ongoing expenses cover plan management and recordkeeping. 
• Employer Contributions: While optional, many employers choose to match employee contributions, which is an additional expense. 

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To offset these costs, the IRS offers tax credits for small businesses starting new retirement plans. Eligible employers may claim a credit of up to $5,000 annually for the first three years, totaling up to $15,000. 

How many days do you have to fund a 401k?

Employers are required to deposit employee 401(k) contributions as soon as reasonably possible after withholding them from wages. The Department of Labor (DOL) mandates that these deposits occur on the earliest date the employer can reasonably segregate the contributions from general assets, which is typically within a few business days.

For small businesses with fewer than 100 participants, the DOL provides a safe harbor period, allowing deposits to be made no later than the 7th business day following the date the contributions were withheld. 

Note that the 15th business day of the following month is not a safe harbor deadline but the maximum limit. Employers are expected to deposit contributions as soon as they are able, and delaying until the 15th business day may not be considered timely if earlier deposit is feasible.

Is there a minimum amount to start a 401k?

Generally, there's no strict minimum amount required to start contributing to a 401(k) plan. In standard 401(k) plans, employees can often begin with small contributions, sometimes just a percentage of their paycheck. The focus is usually on the maximum contribution limits set by the IRS rather than minimums.

However, in automatic enrollment 401(k) plans, employers may set a default contribution rate, commonly around 3% of an employee's salary. While rare, some employers might establish specific minimum contribution requirements for their 401(k) plans.