401(k)s for the Small Business Owner

Businesses have to compete for talent. Even in down economies, the best employees always have options. One of the things employers must do to keep their best workers is offer them a good, robust retirement plan. That’s where the 401(k) comes in:

The 401(k) is a defined contribution pension plan that allows both employee and employer contributions. By offering a 401(k) plan to employees, you as the employer can provide a powerful retirement benefit at a fraction of the cost of funding a traditional defined benefit plan. Beyond a few basic administrative and setup costs, your only ongoing costs as an employer generally consist of whatever matching contributions you choose to make.

For tax year 2014, qualified employees may contribute up to $17,500. Those aged 50 and older can make additional “catch-up” contributions of $5,500. These limits are much larger than those available for IRAs and traditional IRAs, therefore allowing participants to set aside more money on a tax-advantaged basis than they otherwise could manage on their own. *

The Tax Advantage

Contributions to 401(k) plans are made pre-tax via salary deferral. Balances grow tax-deferred. There are no income taxes due on interest or dividends, and no capital gains taxes due on growth. Money is only taxed upon withdrawal. If the participant makes withdrawals prior to age 59½ the IRS generally charges a 10 percent excise tax. The employer must also withhold 20 percent of the amount withdrawn against taxes.

*Note: In some circumstances, the allowable contributions of highly-compensated employees may be lower – especially if management does not get adequate participation among rank and file employees. Congress designed the 401(k) to benefit all employees – not to be a private preserve for management. It is therefore in the best interests of management to encourage broad participation in the plan. The more workers participate, the more highly-compensated management and owners can set aside within their own 401(k) accounts.

Sole Proprietorships and Couples

If you are the sole employee of your corporation or LLC, or you own and operate your company with your spouse, you may consider the Solo 401(k). These are specially designed to be realistic, workable and efficient solutions for ultra-small businesses with few or no employees other than the owner. Sometimes called the “Individual 401(k), or “One-Participant 401(k)s.”

Like other 401(k) plans, these plans allow business owners to set aside up to $17,500 of their own salary via salary deferral as employees.

Additionally, the employer can contribute an additional 25 percent of compensation as defined by the plan.

Self-Employed Individuals

It is also possible for self-employed individuals to create a 401(k) plan to cover themselves as well. In this case, however, you must also calculate the effect of self-employment tax on your allowable contributions.

For self-employed individuals, your compensation for the purposes of calculating maximum allowable contributions is your net self-employment earnings after subtracting your contributions for yourself and one-half of your self-employment tax for the year.

For more information on 401(k) plans for small businesses, including Solo 401(k)s, see IRS Publication 560 – Retirement Plans for Small Business

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