A 401(k) is a savings plan that provides retirement benefits for business owners and their employees. Setting up a Traditional 401(k) for your small business will help you attract and retain top talent while reducing employees’ tax liabilities. For help setting up a 401(k) without spending a fortune, follow our six steps below.
How a 401(k) Plan Works
401(k) plans were created by Congress in 1978, and are regulated by the IRS and the U.S. Department of Labor (DOL). As such, the provisions of the plan are regulated by law. Some of those regulations are mandatory, while others are optional and give the employer significant leeway.
For example, in establishing a 401(k) plan, it must be available to all eligible employees. It can’t provide more generous provisions to you as the owner of the business or to more highly compensated employees (referred to as “HCEs”).
Other mandatory IRS provisions for offering a Traditional 401(k) include:
Limits on How Much an Employee Can Contribute
As of 2019, employees may contribute up to $19,000 to their 401(k) plan, or as much as $25,000 if they are age 50 or older (this is referred to as the “catch-up provision”). Employers may also make matching contributions. Investopedia notes that the average employer contributes about 2.7%.
Rules on Distributions
Participants can begin taking distributions without penalty from the plan as early as age 59 1/2. Those distributions will be taxable as ordinary income. If employees younger than 59 1/2 wish to take out funds, they will be subject to a 10% penalty.
Bonding Requirements
If you manage funds in your company, you must be bonded. Fortunately, this fiduciary bond coverage is fairly inexpensive. The cost can range anywhere from $100 to several hundred dollars.
Non-discrimination Testing
401(k) plans must provide substantive benefits to rank-and-file employees, and not specifically favor you as the owner of the business or other highly compensated employees. Safe Harbor 401(k) plans are generally not subject to annual nondiscrimination testing and may be an alternative.
Prohibited Transactions
There are certain transactions that are prohibited when you sponsor a 401(k) plan. These can include dealing with parties that have certain connections to the plan, self-dealing, and conflicts of interest that could harm the plan.
Follow these six steps for setting up a 401(k) for your small business:
1. Decide on the Type of 401(k) to Offer
According to payroll software provider Gusto, over 90% of businesses offer their employees some kind of retirement savings plan. When offering a retirement plan to your employees, many small business owners opt for the Traditional 401(k) because it allows employees to save up to $19,000 in pretax earnings each year (up to $25,000 if they’re over age 50).
What makes the Traditional 401(k) best is that it can be offered by any size company; however, Gusto suggests that due to the fees involved, it’s best for businesses with an annual payroll of at least $500,000. However, there are other 401(k) options we’ll describe below to help you choose what’s best.
Here are four kinds of 401(k)s that you might consider setting up for your business:
Traditional 401(k)
The most commonly offered 401(k) is the Traditional 401(k). This kind of 401(k) plan is a qualified tax-deferred retirement plan that is set up by an employer for the benefit of a business’ employees. The earnings on 401(k) contributions grow over time, allowing employees to avoid taxes on these savings until the funds are withdrawn (usually at retirement). You, as a business owner, may also receive a tax credit. Most businesses will choose this option as a means to help employees contribute for retirement because the business owner can participate too.
When setting up a Traditional 401(k) plan, you’ll need to contribute to it as well (with pretax dollars), as that’s one of the qualifications for a how a Traditional 401(k) plan works. Offering a small business 401(k) plan caps the total combined (employee and employer) contributions at $56,000 in 2019, or $62,000 for those over age 50.
There are some variations for setting up a 401(k) that may work better for you and your small business depending on, for example, whether you’re a sole proprietor. Some of these options provide unique benefits, such as the Safe Harbor 401(k), which works best if your staff are highly compensated.
Each of these 401(k) options described below includes a link to learn more about how it works.
Solo 401(k)
If you do not yet have any employees, you can set up your own individual 401(k), which is commonly known as a Solo 401(k). This is basically a 401(k) that requires just one participant (such as you, or you and your spouse). It does not matter if your business is a sole proprietorship, a corporation, an S corporation, or even a partnership.
A solo 401(k) plan has the same contribution limits as a Traditional 401(k) and does not require either a setup fee or an annual administrative fee. If you later decide to hire employees, you can simply convert a Solo 401(k) to a Traditional 401(k). To learn more, read our full article describing the contribution limits and rules for a Solo 401(k).
Safe Harbor 401(k)
Traditional 401(k) plans require equal treatment of participants, regardless of rank or income level. However, a Safe Harbor 401(k) plan can give business owners and other highly compensated employees a greater ability to maximize salary deferrals. In addition, all required employer contributions are always 100% vested.
A small business hiring mostly educated, professional staff with only a few lower paid employees might choose this option instead of setting up a Traditional 401(k) plan. A safe harbor plan automatically satisfies the annual nondiscrimination test requirements designed to restrict contributions to the plans of highly compensated employees, referred to as “HCEs.” We provide more information on the contribution limits and rules in our full article covering Safe Harbor 401(k).
Roth 401(k)
With a Roth 401(k), you and your employees make after-tax contributions through salary reductions. The Roth portion of the 401(k) is accounted for separately from the pretax contributions to a Traditional 401(k). Roth IRA plans provide tax-free distributions in retirement. The contributions are not subject to income tax upon withdrawal.
Investment earnings on those contributions can also be taken tax-free, as long as participants have been in the plan for at least five years and are at least 59 1/2 at the time the money is withdrawn. This may be a better option for employers with low wage earners (who don’t need the tax savings of a Traditional 401(k)), or those with older workers approaching retirement.
For a comparison of a Roth to a Traditional 401(k), read our article that compares the two.
Setting up a 401(k) plan benefits everyone—from a single owner or sole proprietor to multinational corporations that employ tens of thousands of workers. Savings within a 401(k) plan can be invested in a wide variety of investments, though they are most often invested in mutual funds. Plan investments can either be professionally managed or completely self-directed by each individual participant.
If you want to set up a Traditional 401(k) plan, you can include a Roth 401(k) plan along with it. That will give you and all of your employees all of the benefits of a Roth IRA within your overall 401(k) plan. However, any employer matching contributions to a Roth 401(k) must be added to the Traditional 401(k), and not the Roth 401(k) itself. To learn more, read our article that covers the ins and outs of a Roth 401(k).
Disclaimer: Fit Small Business does not provide legal and financial advice. If you are concerned about which plan is best for you from a legal or financial point of view, we recommend you chat with your business attorney or tax adviser, who can advise you on the best option.
2. Determine How Much to Contribute to a 401(k) Plan
Once you’ve figured out what kind of 401(k) is best for your business, you’ll want to look at costs and determine how much you can afford to contribute to your own plan and that of your employees in terms of plan matching. You’ll also want to budget for administrative costs to set up and manage your plan.
Here are the kinds of fees that go into setting up a 401(k) plan.
Administrative Costs of Setting Up a 401(k)
The fees that you will pay for a 401(k) plan will depend upon the number of employees covered under the plan, as well as the service provider that you are using to administer the plan. For example, a broker may have an upcharge versus going directly to a 401(k) provider.
As the sponsor of a plan with fewer than 20 employees, you should expect to pay a setup fee in the range of $500 to $1,000 and annual administrative fees between $1,000 and $2,000. Some service providers charge a flat fee based on a numeric range of plan participants, while others charge a per-participant fee.
There are also fees associated with plan participation, usually charged by the trustee of the plan; these are typically paid by the employees themselves (such as investment fees). These may include an annual plan administrative fee of between $50 and $100, as well as trading commissions and mutual fund loads involved in individual investments within the plan.
Employee Contributions
Participation in a Traditional 401(k) is optional for employees. However, some types of 401(k) require a minimum contribution by employees and employer in order for you to earn tax credits. That means you may have to kick in matching funds.
Employer Matching Contributions
Employers may make contributions to each participant’s plan, whether full or partial. A few employers do offer an extremely generous match, such as 100% of the employee’s salary up to the full $19,000 that the employee can contribute.
Here are two ways an employer can contribute to an employee’s 401(k) savings plan.
- Matching contributions: An employer matches an employee’s contribution up to a percentage limit, such as 25%, 50%, or 100% of employee contributions.
- Non-matching contributions: An employer contributes a specified amount regardless of the employee’s saving habits, such as $5,000 a year per full-time employee.
For example, it’s common for employers to offer a 50% matching contribution up to the first 6% of income that the employee contributes to the plan. That means that as an employer, your contribution would be 3% of the employee’s income. Here’s how your contribution might look if you have 25 employees making $40,000 each.
- If every employee contributed the maximum 6% that you match ($2,400), your contribution per employee would be 50% of that amount, or $1,200 per year.
- For 25 employees, that would equal $30,000 that you contribute to their 401(k) plans.
In reality, some employees will contribute more than that (up to the IRS limit) and many will contribute less, even if you help match their contributions. Your best bet is to budget for the maximum contribution amount you provide until you have a better sense of 401(k) participation in your own firm. Then adjust your plan each year going forward based on factors like your business revenues (e.g., if business is down in a given year, you may want to lower your match).
Total contributions into any single employee’s retirement plan, whether provided by the employee or the employer, cannot exceed:
- The employee’s total compensation,
- $56,000 for a participant up to age 50, or
- $62,000 for participants age 50 or older.
Vesting
Eligible employees can make tax-deductible contributions to the 401(k) plan by directing a portion of their salary to the account. Any contributions made to a Traditional 401(k) plan by a participating employee are immediately vested 100%. The employee is entitled to retain those contributions—plus any investment earnings on those funds—even upon termination of employment.
The employee portion is vested immediately, meaning that the employee account is funded the amount right away. Employer contributions can be vested over several years (generally not more than five years). When setting up a vesting program, you might consider accruing the funds but only crediting the funds to the employee’s account at the rate of 20% for every year they work at the firm.
3. Find a Vendor to Set Up the 401(k) Plan
If all of the benefits and requirements of setting up a 401(k) plan for your business seem a bit overwhelming, rest assured that there is plenty of help available—and at a surprisingly low cost. Exactly which provider you will use depends on what kind of investment services work best for you and your employees.
Some of the provider options for setting up a 401(k) include:
Investment Trustees
If you believe that your employees will need professional investment management, you might do well to select a 401(k) company such as a mutual fund family. Each fund within that family is managed by an investment manager. You and your employees pick which funds to invest in. Vanguard is the world’s largest mutual fund provider and a popular choice among 401(k) plans.
If you expect that your employees are already investment savvy, and would prefer self-directed investing, large brokerage firms, like Fidelity, are excellent choices. They provide access to virtually all investment categories along with as much—or as little—direct investment advice as your employees may need or want.
In addition, the larger investment companies, like Spark 401k, are very adept at handling all of the administrative and filing requirements connected with 401(k) plans.
Banks & Financial Institutions
Banks already manage your business checking and savings accounts, and can provide your employees with direct deposit. Therefore, they can often help you with setting up a company 401(k) plan. For example, Spark 401k (by Capital One) offers a low cost 401(k) plan for small business owners.
Payroll Companies
Payroll companies can handle the setup, enrollment, and day-to-day administrative tasks required for a 401(k) plan. Since they handle both regular payroll, the preparation of employer reports, and W-2s, you will have all of the necessary employee-related 401(k) information provided automatically and on time.
Gusto is a perfect example of a small business payroll software that provides full-service benefits offerings, including setting up a 401(k) at very affordable rates. This includes providing quarterly statements as well as year-end filing requirements. Gusto also provides new clients with a 30-day free trial, with their first payroll free.
Professional Employer Organization (PEO)
Some businesses prefer to turn over their HR management to a co-employer. A professional employer organization (PEO) provides full-service HR, benefits, and payroll management, and often provides price breaks on popular employee benefits like a 401(k) or insurance like workers’ comp due to their tremendous buying power.
Justworks is an example of a PEO that can provide full HR, payroll, and benefits, including a 401(k) with prices that start under $100 per employee, per month. It gives employees an HR portal they can use to access their retirement data and can take the back-office benefits work off your plate. Get a free demo.
Employee HR & Benefits Companies
Benefits providers focus on offering employee benefits plans, including 401(k) plans to employees. Some, like Zenefits, also offer HR consulting and other benefits for an additional fee. As a small business, you might consider comparing Zenefits to Gusto and choose the provider that’s best for your 401(k) needs based on your company size and growth plans. Contact Zenefits for a demo.
4. Document Your 401(k) Plan & Rules
There is a considerable amount of time, effort, and detail involved in setting up and documenting a 401(k) plan before you roll it out to your employees. It’s best to enlist the help of your investment trustee (brokerage or mutual fund company), your payroll company, or 401(k) benefits administrator, who may include documentation as part of their services or offer to help with management for a small service fee.
Here’s what you need to document for your 401(k) plan:
- 401(k) plan document: This written plan document spells out the terms of the 401(k), such as how to participate and how much the company will match.
- Investment options: As the sponsor of the 401(k) plan, you can determine the type of diverse investments that participants can invest their money in.
- Trustee: This is the investment company—either a brokerage firm or a mutual fund family. It is the vehicle in which plan participants will invest their money.
- Recordkeeping system: Determine how you’re tracking and allocating contributions and accounts for participants as well as how you will manage investment earnings, expenses, and benefits distributions.
If you’re looking for payroll software that can provide you and your employees with retirement options like a Traditional 401(k) and also manage the required tax returns and reports, consider working with Gusto. Prices start at $45 per month, and it provides your employees with a self-service portal to view and monitor their accounts online. Get your 30-day trial.
5. Embrace Your Fiduciary Responsibilities & 401(k) Reporting
As the sponsor of a 401(k) plan, you’ll have certain additional responsibilities, called “fiduciary responsibilities.” According to the Department of Labor (DOL), those responsibilities include:
- Setting up plans that benefit your employees (and their dependents and beneficiaries)
- Keeping plan costs reasonable
- Being accurate and careful with the plan and all monies invested
- Complying with plan rules and document requirements
- Giving employees diverse investment options
If you hire a third party to manage the plan for you, these fiduciary responsibilities also apply to them as well as you, the plan sponsor. Most third-party 401(k) providers will help you manage any auditing, testing, and reporting you need for IRS and DOL compliance.
401(k) Reporting
Additionally, there are three primary reporting documents, or “returns,” that may be provided to the Internal Revenue Service (IRS) annually when you sponsor a 401(k) plan. Some of these documents are only required of employers whose 401(k) funds reach a certain threshold, such as $250,000:
Form 5500: Annual Return & Report of Employee Benefit Plans
This is a required information return that discloses details about your 401(k) plan and its operation to both the IRS and the DOL. It must be filed electronically, and it will be made available to the public.
Form 8955-SSA: Annual Registration Statement Identifying Separated Participants With Deferred Vested Benefits
You must file this return to report separated participants (i.e., terminated employees) who have deferred vested benefits. It is filed with the IRS and also provided to the Social Security Administration, which provides the reported information to the participants when they file for Social Security benefits.
Form 1099-R: Distributions From Pensions, Annuities, Retirement, or Profit-sharing Plans, IRAs & Insurance Contracts
Form 1099-R may be required to report distributions (including rollovers) from the 401(k) plan (for example, if the amount distributed for a withdrawal or a loan is over $10). It is provided to both the IRS and the recipient of any distributions made from the plan during the calendar year.
Spark 401k offers small businesses Traditional 401(k) plans, safe harbor plans, and solo 401(k) plans that are affordable and easy to set up. Not only that, but they cost up to 66% less than the industry average. Get started with Spark 401k and a 401(k) adviser will help you select the right plan for you and your business.
6. Launch Your 401(k) Plan & Enroll Employees
You must inform plan participants about the benefits, rights, and features of the 401(k) plan, as well as the rules (who can enroll and when) and options that are available to them. They will also need to be sent monthly, quarterly, or annual account statements to confirm their investment in the plan.
There are two ways to enroll participants in your 401(k) plan:
1. Automatic Enrollment
Many small businesses find it best to enroll new employees in the 401(k) plan with standard payroll deductions, such as 3% to fund their accounts. This option allows you to invest their money in default investments. Going this route tends to increase enrollment and participation, and you can always allow employees to change how much they contribute.
2. Employee-chosen Contributions
With employee-chosen contributions, the employee chooses whether to participate and determines how much to contribute. This option typically results in a lower participation rate, as it requires the employee to “do something.” Employees often don’t understand the benefits to them (retirement savings and reduced income taxes). Therefore, it takes more work on your part to get them to sign up.
In either case, payroll deductions must be coordinated between your payroll provider and the investment trustee, which is why some small businesses prefer to set up their 401(k) account with a PEO or payroll provider. Contribution elections are established either during onboarding or when the employee becomes eligible to participate in the plan (if you have a waiting period).
Furthermore, you may find there are benefits to launching your program at the start of a fiscal year or tax quarter in order to optimize tax savings for both you and your employees. Talk with your 401(k) plan provider to determine the best time of year to launch your 401(k).
Plan Exclusions
Some employers choose to make their 401(k) plan only available to workers who meet certain criteria, such as those who have completed their 90-day probation period or employees over 18 years old. However, there are rules as to who can be excluded.
Employees may be excluded from the plan only under very limited conditions:
- Age: Employees can be excluded if they are under age 21
- Time worked: Employees who have worked for you for less than one year
- Union members: Subject to what’s provided in collective bargaining agreements
- Certain nonresident aliens: Including those without a green card
Pros &d Cons of Setting Up a 401(k) plan
Once your business is in a financial position to offer retirement benefits, it’s time to take a close look at sponsoring a 401(k) plan. It’s one of the best retirement plan options available, particularly for small business hoping to attract and retain top talent. However, there are both ups and downs to setting up a 401(k).
Pros of Setting Up a Small Business 401(k)
The Society for Human Resource Management (SHRM) reports that retirement benefits are near the top of the list (surpassed only by paid time off and health insurance) of benefits workers want. You may even want that for yourself.
Here are some of the compelling reasons to start a 401(k) plan:
- To provide a comprehensive retirement plan for yourself: If your business is beginning to generate significant profits, you can invest in your own retirement.
- To shield some income from taxes: Since 401(k) plan contributions use pretax dollars, what you contribute for yourself and the amount you match for your employees reduces your income, their income taxes, and your payroll taxes.
- To attract and retain talented employees to your business: Employee participation in a vested 401(k) plan provides strong motivation for a person to stay with your firm.
Cons of Setting Up a Small Business 401(k)
401(k) plans contain provisions that you need to be aware of with respect to management and tax filings. If you’re using a third-party service provider, they will handle most of these potential obstacles for you.
Here are some downsides to watch out for:
- Non-discrimination testing: Testing must be done annually to compare plan participation between high earners and other employees.
- Prohibited transactions and exemptions: This can apply to buying, selling, or holding investments, as well as the collection of fees and compensation by the investment adviser. You’ll need the help of a 401(k) partner to ensure compliance.
- Bonding requirements: If you manage the funds, your bond must equal at least 10% of the amount that you handled the previous year, subject to a maximum of $500,000.
- Penalties: The U.S. DOL has a list of violations with monetary penalties in connection to 401(k) plans. For example, not filing Form 5500 can cost up to $2,063 per day.
- Taxable withdrawals: Traditional 401(k) distributions are subject to ordinary income tax. And if funds are withdrawn prior to the participant reaching the age of 59 1/2, there is also a 10% early withdrawal penalty.
Frequently Asked Questions (FAQs) About Setting Up a 401(k)
Setting up a 401(k) for your small business may spark questions from you and your employees. We’ve answered the most common below and encourage you to post additional questions to our forum.
Can my employees take money out of their 401(k)?
Participants can withdraw funds from a 401(k) plan at virtually any time—it’s just a matter of how much they will pay in taxes and penalties as a result. If they take the money out prior to turning age 59 1/2, they’ll pay income taxes and a 10% penalty.
Can a 401(k) be set up so that employees can take a loan from it?
Regulations allow employers to offer loans to the participants of a 401(k) plan. However, an employer is not required to make such a provision. The maximum loan permitted is $50,000, but it may be lower if the participant doesn’t have at least twice that amount in their account.
What are the contribution limits for a Traditional 401(k)?
The limits change annually, so it’s best to refer to the IRS website for the current limits. In 2019, the total combined limits are:
- Low-earning employees: The limit is the employee’s total compensation, i.e., if an employee earns only $12,000 a year, they can’t contribute more than that to their 401(k).
- Employees age 50 and younger: The total combined limit is $56,000
- Participants age 50 and older: The total combined limit is $62,000, as it includes the $56,000 plus up to $5,000 employee and $1,000 employer catch-up contributions.
What is a hardship withdrawal?
As the plan sponsor, you have the option to allow participants to access a portion of their plan funds for financial hardships without the 10% early withdrawal penalty. You are not required to offer this feature and there are significant rules involved.
Hardship withdrawals must generally relate to the following needs:
- Certain medical expenses
- Costs relating to the purchase of a principal residence
- Tuition and related educational fees and expenses
- Payments necessary to prevent eviction from, or foreclosure on, a principal residence
- Burial or funeral expenses
- Certain expenses for the repair of damage to the employee’s principal residence
What is the required minimum distribution (RMD)?
Required minimum distributions are a provision that applies to all tax-sheltered retirement plans except Roth plans. It requires that participants in 401(k) and other pension plans begin taking mandatory distributions from the plan upon reaching the age of 70 1/2. The distributions are based on the participant’s life expectancy and are subject to ordinary income tax.
Does the IRS provide guidance on 401(k)?
Yes, but it’s the IRS, so you’ll need to wade through a bit of jargon.
Bottom Line
If you are comfortable that your business is on solid ground, it may be time to consider adding a 401(k) plan to your employee benefits mix. This will be especially important if you want to save for your own retirement, want to shelter some of your income from taxes, or if you want to attract and retain talented employees.
Spark 401k offers small businesses Traditional 401(k) plans, Safe Harbor 401(k) plans, and Solo 401(k) plans that are affordable and easy to set up. Not only that, but they cost up to 66% less than the industry average. Get started with Spark 401k and a 401(k) adviser will help you select the right plan for you and your business.
