Tax Implications of 401(k) Program for a Business

by Steve Lander

401(k) plans help you and your employees save for retirement with pre-tax dollars, letting you have more money grow until you need to take out out. When a 401(k) is well-structured, it can increase employee morale and retention. Nevertheless, based on a survey from a major payroll provider, more than 70 percent of small businesses don't offer 401(k)s to their employees. While the perception that 401(k)s are expensive may be behind the reluctance of some businesses to set up plans, they can actually provide valuable tax savings.

Tax Credits

The IRS realizes that setting up and administering a 401(k) plan can be expensive for small businesses. As such, if you have 100 or fewer employees, you might be eligible for a tax credit for the cost of starting up a 401(k) or other pension plan. You can claim half of the total expense for establishing, administering or educating your employees about your plan, up to $500, for the first three years of the plan's existence. Instead of a deduction, this is a credit, so it reduces your taxes on a dollar-by-dollar basis.

Tax on Employee Contributions

Unfortunately, you don't get out of paying tax on the money that your employees put into their 401(k) accounts. You usually won't have to withhold state or federal income tax for them, but they will have to pay their Social Security and Medicare tax. You are also expected to pay the employer's share of the payroll taxes on the employee contribution as well.

Tax on Employer Match

If you match your employees' contributions, that money is tax-free. Your employees don't pay income or payroll tax on it, and you don't either. You also don't have to pay federal unemployment tax on it, and workers' compensation insurance carriers let you exclude it from your wage calculation for their purposes as well. At the same time, you still get to claim an expense on your business's tax return for the money that you contributed to your employees' accounts.

Benefit to Owner

As the owner of the business, you also gain personally from having your company set up a 401(k) plan. As of 2013, the IRA contribution limit was $5,500, or $6,500 if you're over 50. However, you can put $17,500 into your 401(k), plus an additional $5,500 if you're 50 or above. Structuring your company's 401(k) as a Roth plan also lets you take advantage of a Roth even if your income is above the limit for a Roth IRA. With a Roth, deposits into the retirement account are taxed, but withdrawals are tax-free.

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