Posted by Mike Kelly, CPA
Are you thinking about offering a 401(k) Plan as a new benefit to your employees? If so, this blog might help you navigate through some of the tax savings and other features associated with implementing a 401(k) for a company.
A 401(k) plan allows employees of a company to defer wages (pretax) into their retirement accounts.
So what does deferral do for you tax-wise? The 2015 annual limit for deferrals, which cannot exceed an employee’s compensation, is $18,000. The limit is adjusted annually for inflation, and there is also a catch-up contribution of $6,000 available when the employee attains the age of 50. If a 401(k) plan is in effect for an employee’s company, $18,000 of his wages would not be subject to income tax. Assuming that the taxpayer is in a 35% combined federal and state income tax bracket, this would result in estimated tax savings of $6,300 for the employee.
Please note the $18,000 would still be subject to employer and employee payroll taxes of 15.3%.
A 401(k)/profit sharing plan also allows the employer to make contributions to the employee’s retirement account. The company will receive a deduction for the contributions and the employee(s) will not be taxed on them. This deduction is limited to 25% of the total eligible compensation paid to all of the company’s eligible employees.
The current limit for annual additions to participant accounts is limited to the lesser of compensation paid or $53,000 per year. This limit includes employer contributions and elective deferrals. Assume the sole shareholder employee of an S-corporation earns $25,000 of wages. The total compensation paid by the company is $25,000; therefore the company can deduct $6,250 (25% of $25,000) for contributions made to the employee’s retirement account. Assume the shareholder made the full $18,000 deferral previously discussed. He would be allocated a contribution of $24,250 [(25% of $25,000) +$18,000] to his retirement account during the year, which is well short of the $53,000 maximum allocation. Most importantly, compensation includes W-2 wages (from the employer with the 401(k) plan) but does not include the earnings on an S-corporation K-1 that flows through from the employer to the shareholder’s individual returns.
The shareholder could only increase his contribution if the company increased his salary. In order to maximize all of the contributions, the company would have to pay at least the employee $140,000. Therefore, the maximum deduction using the 2015 limitations would be computed as follows:
|Profit Sharing:||35,000 (25% of 140,000)|
The wage increase would be subject to additional payroll taxes of 15.3%; however, the 2015 social security wage base is $118,500. Any wages paid in excess of this amount are only subject to the Medicare portion of the payroll tax (2.9%). Also, a higher wage base would mean higher social security benefits at retirement. Also, in the case of S-corporation shareholder employees, it would help to minimize the chances of an IRS inquiry into the reasonableness of an employee’s wages, as this is an area of IRS scrutiny. Last, but not least, the profit-sharing contribution is NOT subject to payroll taxes. Therefore, in the above scenario, the sole shareholder could effectively shield $35,000 of retirement income from payroll taxes. The entire $53,000 would give the shareholder a current income tax deduction.
If the company grows and makes more profits, the shareholder should consider maximizing the employer’s contribution while eliminating the 401K elective deferral. As mentioned above, unlike employer contributions, 401(k) elective deferrals are subject to payroll taxes. To fully benefit from this tax favorable treatment, the shareholder would have to pay himself $208,000 in W-2 wages for the company to be able to deduct the full $53,000 (25% of $212,000) employer contribution. This would effectively eliminate the company’s portion of payroll taxes $4,054 (7.65% of $53,000) associated with the contribution.
Partners inside a partnership do not receive wages so their contribution and deduction ceilings are based on the partner’s self-employment earnings from the partnership.
There are certain complicated discrimination testing requirements associated with retirement plans. This testing ensures business owners and other highly compensated employees do not receive a disproportionate benefit from a retirement plan when compared with the benefit received by the rank and file employees. The most common way to avoid these testing requirements is to offer a safe harbor match for all employees. This means that if the company has other employees who make elective deferrals to their 401(k), the company would be required to match a portion of their deferrals by making contributions to the their accounts. A safe harbor plan needs to be established by October 1 of the plan year preceding the calendar year in which it becomes effective.
Also, if a profit sharing contribution is made, it generally would have to be allocated among all employees based on compensation. The maximum compensation allowed in this calculation is $260,000 per employee. Be careful though because profit-sharing contributions to a safe harbor plan triggers top-heavy testing.
A 401(k) plan must be established by December 31 of the tax year that you wish it to become effective.
Besides a few limited exceptions, you typically cannot withdraw retirement funds until age 59½; otherwise you will be subject to a 10% early withdrawal penalty. All distributions of pre-tax dollars will be taxable at your ordinary tax rates upon withdrawal.
A 401(k) profit sharing plan is one of the most powerful tax-savings tools available. It’s also a good way to attract new employees. If an organization has the available funds, it should implement a plan. As always, talk with your accountant when thinking about offering a benefit like a 401(k) plan to ensure it is the right decision for your company.