401(k) Tax Benefits For Business Owners

Tax strategies are important for any employer, but especially for the owners of small and mid-sized businesses looking to make the most of every dollar. In a recent survey published by Forbes, 93% of business owners polled have overpaid on their taxes at some point over the last 12 years.¹  The traditional 401(k) plan offers a great way to save for retirement, sure, but it can do much more than that for entrepreneurs. Your 401(k) can also help a lot with your tax strategies.

Below are three different types of 401(k) plans and the unique tax advantages they each present. You may find there’s a way for you to pay less out to the IRS while saving more for your future.

How Does A 401(k) Affect My Taxes?

When you save money in your 401(k), it gets deducted from your paycheck and placed directly into your 401(k) account. That amount is then deducted from your taxable income for the year, effectively lowering your tax liability (up to the annual limit of $23,000). You will eventually pay taxes on that money when you withdraw it from your 401(k) in retirement. In the meantime, that means you have more money to invest and grow for the future!

The General Tax Benefits Of A Traditional 401(k) Plan

At its simplest, a traditional 401(k) plan offers anyone who participates the benefit of the pre-tax savings we mention above. By setting aside a certain percentage of your salary (up to $23,000 in 2024, or $30,500 if you’re 50 years or older) into your 401(k) account, you can lower your taxable income by that amount in the present and defer paying taxes on that money until you withdraw it in retirement.

Employers can also choose to make matching contributions to their employees’ accounts. That includes the accounts of business owners.

You could, for example, choose to offer to match any savings made by employees up to 4% of their annual salary. This is a great perk for anyone who takes advantage of it, but it also presents another tax benefit to business owners: Those employer contributions are deductible as a business expense.

Finally, the IRS has created a small business tax credit to incentivize business to start 401(k) plans. Currently, employers with 100 or fewer employees can write off up to 50% of startup costs of a new 401(k) plan, up to $500 per year for the first three years of a plan. This credit can be moved forward or back to other tax years in case you’ve already reached your maximum deduction for the year it becomes available. Speak with a tax attorney to know how the credit affects your specific situation.

Increased 401(k) Tax Savings With Profit Sharing Plans

There are many ways to customize 401(k) plans to meet your company’s unique needs. One common type of plan customization is the 401(k) with profit sharing. This type of plan offers many of the same tax benefits of a traditional 401(k) plan—but with higher contribution limits for more tax savings. In a profit sharing plan, employers make contributions to employee retirement savings accounts based on the company’s profitability in a year. These plans are very flexible when it comes to the employer determining how much they will offer. That means you are free to choose how much you want to contribute in a given year, or even to skip making contributions when profits are low.

When combined with the 401(k) tax advantage of a traditional plan, profit sharing plans also allow employees to save their own money up to the normal contribution limits of $23,000. Maximum employer contribution limits are even higher: Up to 100% of an employee’s annual salary or $69,000 per year ($76,500 for employees 50 and over), whichever is higher. That $23,000 limit is a combined top end, meaning employee and employer contributions combined cannot exceed it.²

Cash Balance Plans: The Ultimate In 401(k) Tax Savings

Over the past several decades, defined contribution plans like 401(k) have largely replaced defined benefit plans. Plans of this type, like pensions, are based not on a certain employer contribution rate but on a guaranteed benefit to be received in retirement.³ That said, a specific type of defined benefit plan—the cash balance plan—has seen a recent rise in popularity for its ability to pair with a traditional 401(k) with profit sharing and offer tremendous tax benefits.

Because they are defined benefit plans, all the money in a cash balance plan is contributed by the employer. These plans work best if your business has steady profits and you are able to commit long-term to converting a significant portion of your personal income into cash balance contributions. For 2024, a cash balance plan could allow you to contribute anywhere between $91,000 and $409,000 of income per year. And when paired with a profit sharing plan, the upper limit is actually $485,500 total. For an owner who is 50 years old and contributes the maximum amount to a cash balance plan paired with a 401(k) with profit sharing, that’s a total tax savings of $76,730 per year, assuming a 40% tax bracket.

There is another major benefit to cash balance: If done right, a cash balance plan could be the key to helping you lower your annual income below the current limit for the new 20% tax deduction. Under current tax law, married tax filers who make less than $383,900 per year and single filers who make under $191,950 qualify for this 20% deduction.⁴

Many employers choose 401(k) plans for their flexibility in helping employees, including the owners themselves, to prepare for retirement. Take a closer look at the 401(k) options available for your small or mid-sized business and consider how the right plan could also give you just the tax savings you’ve been looking for.

¹https://www.forbes.com/sites/groupthink/2015/06/09/entrepreneurs-stop-overpaying-on-taxes/#debd8d43f708

²https://www.ars401k.com/reminder/2019-401k-profit-sharing-plan-annual-limits

³https://20somethingfinance.com/pensions-vs-401ks-why-you-should-care-that-pensions-are-going-extinct/

⁴https://www.bloomberg.com/news/articles/2018-08-15/rich-professionals-barred-from-tax-break-find-pension-painkiller