Small Business 401k Rules for Employers

A small business 401k plan is a company-sponsored retirement program where employees contribute a portion of their wages on a tax-deferred basis. Employers can also make tax-deductible contributions to employee accounts. The funds within the plan grow tax-deferred until withdrawn in retirement, making these plans an effective way to attract and retain talent.

The design of a 401k plan is flexible, allowing business owners to tailor features like eligibility and contribution types. However, establishing and maintaining a plan involves legal and administrative responsibilities. These duties ensure the plan complies with federal regulations and maintains its tax-favored status.

Types of Small Business 401k Plans

A traditional 401k plan is a flexible option that allows employees to make pre-tax contributions from their paychecks. Employers have the discretion to make matching or non-elective contributions. This type of plan is subject to annual nondiscrimination testing to ensure it does not disproportionately benefit high-earning employees.

For self-employed individuals or business owners with no employees other than a spouse, the Solo 401k is a specialized option. This plan allows the owner to contribute as both the “employee” and the “employer.” This structure allows for higher annual contribution limits, maximizing retirement savings and tax deductions.

A SIMPLE 401k is designed for businesses with 100 or fewer employees and offers a streamlined approach to retirement benefits. This plan is exempt from the annual nondiscrimination tests that apply to traditional 401k plans, which reduces administrative complexity. In exchange, employers are required to make contributions that are immediately 100% vested.

A Safe Harbor 401k is a version of a traditional 401k that automatically satisfies most nondiscrimination testing requirements. This is achieved by the employer committing to specific contribution formulas, which can be either a matching or a non-elective contribution. These employer contributions must be fully vested when made.

Participant Eligibility and Contribution Rules

Federal regulations establish minimum standards for when an employee must be allowed to participate in a 401k plan. An employer cannot require an employee to be older than 21 or to have completed more than one year of service, defined as a 12-month period with at least 1,000 hours worked. As of 2025, an employee must also be made eligible if they have worked at least 500 hours per year for two consecutive years.

Contribution limits are set annually by the IRS. For 2025, an employee can contribute up to $23,500 from their salary. Individuals aged 50 and over can make additional “catch-up” contributions of $7,500. A higher catch-up limit of $11,250 applies to participants aged 60, 61, 62, and 63.

Beyond employee contributions, plans can also receive employer contributions. These can be structured as matching contributions, where the employer matches a percentage of an employee’s savings, or as non-elective contributions made for all eligible employees. The total combined contributions from both the employee and employer cannot exceed 100% of the employee’s compensation or a specific dollar limit, which is $70,000 for 2025.

Vesting determines when an employee has full ownership of the employer’s contributions. An employee’s own salary deferrals are always 100% vested. For employer contributions, businesses can implement a vesting schedule to encourage retention. Two common schedules are a “cliff” schedule, where an employee becomes 100% vested after a specific period like three years, or a “graded” schedule, where vesting increases incrementally over time.

Fiduciary Responsibilities and Nondiscrimination Testing

An employer who sponsors a 401k plan assumes the role of a fiduciary under the Employee Retirement Income Security Act of 1974 (ERISA). A fiduciary must act solely in the best interest of the plan participants. This includes prudently selecting and monitoring the plan’s investment options, ensuring investment diversification, and administering the plan according to the official plan document.

To ensure a 401k plan does not unfairly favor certain employees, most plans must undergo annual nondiscrimination testing (NDT). These tests verify that the benefits for Highly Compensated Employees (HCEs) are not disproportionately greater than those for Non-Highly Compensated Employees (NHCEs). For the 2025 plan year, an employee is an HCE if they own more than 5% of the business or earned more than $155,000 in 2024.

The primary tests are the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test. The ADP test compares the average salary deferral rates of HCEs to those of NHCEs, while the ACP test does the same for employer matching and employee after-tax contributions. A separate top-heavy test is also required to determine if more than 60% of the plan’s assets are held by key employees.

If a plan fails NDT, the employer must take corrective action, such as refunding contributions to HCEs or making additional contributions to NHCEs. Adopting a Safe Harbor 401k plan design is a common strategy to automatically satisfy the ADP and ACP tests. This avoids the risk and administrative burden of potential failure.

Information and Decisions for Plan Establishment

When setting up a 401k plan, a business must select a provider, such as a payroll company, bank, or specialized administrator. It is important to compare factors like:

• Administrative fees
• The range and quality of investment options
• The level of support for plan administration
• Compliance support

The business must provide its Employer Identification Number (EIN) and a detailed employee census. The census must list all employees with their full names, dates of birth, dates of hire, and compensation for the year. This data is used to determine eligibility and conduct compliance testing.

A formal written plan document governs the 401k plan and is created by making several design decisions. The employer must specify the eligibility requirements for participation, such as minimum age and service period.

The plan document must also detail the vesting schedule for any employer contributions. The business must decide whether to include features like plan loans or Roth 401k contributions, which are made on an after-tax basis. Finally, the document must define the formula for any employer contributions.

Annual Administration and Reporting Process

Once a 401k plan is established, the employer is responsible for its ongoing operation. Recurring administrative tasks include:

• Enrolling employees as soon as they meet eligibility requirements
• Processing enrollment paperwork in a timely manner
• Depositing all contributions on time
• Accurately tracking each employee’s service to apply the vesting schedule
• Processing participant requests for distributions or loans
• Providing all legally required notices to participants

A critical responsibility is the timely deposit of contributions. Employee salary deferrals must be deposited into the plan trust as soon as they can be reasonably segregated from the company’s assets, but no later than the 15th business day of the following month.

Most 401k plan sponsors must file an annual report with the Department of Labor using Form 5500. Businesses with fewer than 100 participants can file the shorter Form 5500-SF. The standard deadline for filing is the last day of the seventh month following the end of the plan year, which is July 31 for a calendar-year plan. A 2.5-month extension can be filed, moving the deadline to October 15.