How Does a 401(k) Benefit the Employer?

A 401(k) is a company-sponsored retirement savings plan that allows employees to invest a portion of their paycheck before taxes. This arrangement provides a structured way for workers to accumulate funds for retirement. For an employer, a 401(k) is a significant component of the overall benefits package, and its administration involves specific IRS rules governing contributions and distributions.

Financial and Tax Advantages

One of the most direct financial benefits for a business offering a 401(k) is the ability to deduct contributions made on behalf of employees. These contributions can be matching funds or non-elective profit-sharing. For example, if a company contributes $50,000 to its employees’ 401(k) accounts in a given year, it can deduct that amount from its corporate income, lowering its tax liability.

The SECURE 2.0 Act of 2022 enhanced the tax credits available to small businesses for starting a new retirement plan. For employers with 50 or fewer employees, a tax credit can cover 100% of qualified startup costs, capped annually at $5,000, but cannot exceed $250 per non-highly compensated employee. For businesses with 51 to 100 employees, the credit covers 50% of qualified costs, also capped at $5,000 per year. These credits are available for the plan’s first three years and directly offset fees for plan setup and administration.

A separate credit exists to encourage employer contributions, worth up to $1,000 per employee for businesses with 100 or fewer employees. For those with 50 or fewer employees, the credit is available for the plan’s first five years, starting at 100% of contributions for the first two years and phasing down over the next three. Employers who add an automatic enrollment feature to their 401(k) can claim an additional tax credit of $500 per year for three years.

The financial advantages extend to business owners, who can participate in the plan as employees. This allows them to save for their own retirement using the same tax-advantaged structure. Contributions made to their accounts grow tax-deferred, meaning taxes are not paid on investment earnings until the money is withdrawn in retirement.

Employee Recruitment and Retention

A strong benefits package is a tool for attracting qualified candidates, and a 401(k) plan is often an expectation. Job seekers may view the availability of a retirement plan as a sign of a stable employer. Offering a 401(k) allows a business to compete more effectively for talent against larger corporations.

Vesting schedules for employer contributions are a feature for retaining employees and reducing turnover. Vesting determines when an employee gains full ownership of the money the employer has contributed to their account. While employees always have 100% ownership of their own savings, employer matching funds or profit-sharing can be subject to a timeline that encourages loyalty.

There are two common types of vesting schedules. A “cliff” vesting schedule means an employee becomes 100% vested in employer contributions after a specific period, such as three years, but forfeits those funds if they leave earlier. A “graded” vesting schedule allows an employee to gradually gain ownership over time, for instance, becoming 20% vested after two years of service and an additional 20% each year until fully vested.

The cost of employee turnover, including recruitment and training, can be substantial. By improving retention through a vesting schedule, a 401(k) plan can provide a significant return on investment for the business.

Plan Design and Contribution Flexibility

Employers have flexibility in structuring their 401(k) contribution formula. A popular approach is the employer match, where the company’s contribution is tied to an employee’s savings rate. A common formula is for the employer to match 100% of an employee’s contribution up to the first 3% of their salary, and 50% on the next 2%.

Another option is making discretionary profit-sharing contributions. Unlike a matching formula, these are not dependent on employee savings. The employer can decide each year whether to make a contribution and how much to give based on the company’s profitability, rewarding employees during successful years without a fixed commitment.

For businesses concerned about administrative burdens, a Safe Harbor 401(k) plan offers a streamlined alternative. These plans require the employer to make a specific contribution—either a minimum match or a contribution to all eligible employees. These employer contributions must vest immediately, though plans with a Qualified Automatic Contribution Arrangement (QACA) can require two years of service for vesting.

In exchange for these mandatory contributions, the plan automatically satisfies certain annual IRS non-discrimination tests. These tests are designed to ensure a plan does not unfairly benefit highly compensated employees. Adopting a Safe Harbor design avoids the complex testing process and allows all employees, including owners, to contribute the maximum amount without restriction.