Are 401(k) Contributions Tax Deductible for Employers?

Seize the tax deductions (and credits!). Contributing to employees’ 401(k) accounts may cost less than you think.

Hand inserting coin into slot

Vehicle expenses. Salaries. Office supplies. Rent. Utilities. Many business expenses can be claimed as tax deductions. But did you know that 401(k) plan contributions offer significant tax benefits, too? Read on to discover all the ways you can save on your tax bill.

Snag the tax deductions

Great news! Whether you decide to make employer matching contributions, profit sharing contributions, or safe harbor contributions to employee retirement accounts, they’re tax deductible. That means that you can subtract the value from your company’s taxable income.

According to the IRS, employer contributions are deductible as long as they “don’t exceed the limitations described in section 404 of the Internal Revenue Code.” Wondering about the limits? Well, in 2020 the employer contribution limit is 25% of an employee’s compensation (eligible compensation is limited to $285,000 per participant). In addition, combined employer and employee contributions are limited to the lessor of $57,000 or 100% of the employee’s annual compensation.

The tax benefits don’t end there…

In addition to claiming big deductions by making employer contributions to your retirement plan, you can also save on taxes in a multitude of other ways.

1. 401(k) administration fees—Administrative fees are typically a business tax deduction. So not only does paying for administrative fees reduce the amount that comes out of individual 401(k) accounts, but they qualify as a business expense, thus reducing your business taxable income.

2. SECURE Act tax credits—Thanks to the Setting Every Community Up for Retirement Enhancement Act of 2019 (the SECURE Act), you may be eligible for valuable tax credits for small employers. Even more valuable than a tax deduction, a tax credit subtracts the value from the taxes you owe! Plus, you can claim these credits for the first three years the plan or feature is in place:

  • Tax credit for new plans—You may now be able to claim annual tax credits of 50% of the cost to establish and administer a retirement savings plan, up to the greater of:
    •  $500; or
    •  the lesser of: $250 per eligible non-highly compensated employee eligible for the plan; and $5,000. (Up to $15,000 in tax credits over three years!)
  • Tax credit for adding eligible automatic enrollment—Earn an additional $500 annual tax credit for adding an eligible automatic enrollment feature to your new or existing plan. (Up to $1,500 in tax credits over three years!)

3. Benefit from your own contributions—Plan on contributing to your own 401(k) plan? You’ll save on your own taxes, too! In 2020, you can contribute up to $19,500 to your 401(k), and if you’re age 50 or older, you can make additional catch-up contributions of up to $6,500. Select either:

  • Traditional 401(k) contributions with pretax dollars to enjoy the benefits of tax-deferred saving; or
  • Roth 401(k) contributions with post-tax dollars, enabling you to make tax-free withdrawals in retirement

Plus, offering your employees matching, profit-sharing, or safe harbor contributions may mean that you can increase your own personal contributions. That’s because, due to the mechanics of discrimination testing, higher 401(k) contributions made by non-highly compensated employees may help to increase allowable contributions for highly compensated employees. Learn more now.

Reward your employees (and improve your company’s productivity)

In addition to helping retain existing employees, a match is a powerful recruitment tool. In fact, a recent Betterment for Business study found that, for more than 45 percent of respondents, an employer’s decision to offer a 401(k) match was a factor in whether or not they took the job.

Plus, you’d be surprised at the hidden costs of not offering an employer contribution. Just look at employee replacement and retention costs. When employers do not help facilitate employee retirement planning, they may be surprised by other costs that could rise, including higher relative salaries (beyond what might have been planned for), higher healthcare costs, or costs associated with loss of productivity.

If the connection seems hard to believe, take a look at the research. According to a study from Prudential, every year an employee delays their retirement, it can cost their employer more than $50,000 due to a combination of factors including higher relative salaries, higher health care costs, younger employee retention through promotion, and several other elements.

For companies that may be less concerned with an aging employee population, forgoing matches can still contribute to rising retention and replacement costs due to the impact of financial distress on employee performance. In a survey by the Society for Human Resource Management (SHRM), which measured the impact of personal financial stress on employee performance, 47% of HR professionals noticed that employees struggle with their “ability to focus on work.” Poor productivity not only costs the business in output, but can inevitably lead to higher employee turnover, which can lead to higher costs associated with retention and hiring.

Make a smart compensation decision

Are you debating between giving employees a raise and offering them a 401(k) plan contribution? Consider this example using $3,000.

A $3,000 increase in base pay will mean a net increase to the employee of just $2,250, assuming 25% in income taxes and FICA combined. For the employer, that increase will cost $2,422.12, after FICA adjusted for a 25% in income tax rate.

Employee Income After-Tax Employer Net Cost
$3,000.00 Increased Pay $3,000.00 Increased Payroll
($750.00) Taxes @ 25% $229.50 FICA @ 7.65%
    ($807.38) Tax Deduction @ 25%
$2,250.00 Net Paycheck $2,422.12 Net Cost

Alternatively, a $3,000 contribution to an employer-sponsored 401(k) plan results in no FICA for either the employee or the employer.  The employee would receive the full benefit of that $3,000 today on a pre-tax basis PLUS it would grow tax-free until retirement. As the employer, your tax deduction on that 401(k) contribution would be $750, meaning your cost is just $2,250 —or 7% less than if you had provided a $3,000 salary increase.

Betterment can help boost tax savings even more...

After you set up your 401(k) plan with Betterment, your employees can start investing for retirement and save on current taxes if they decide to save on a pre-tax basis. But Betterment provides additional tax saving strategies for those employees with two or more Betterment account types (including pre-tax 401(k) and Roth 401(k), but also a retail account) can have their investments optimized by using our Tax Coordination feature at no additional cost. This strategy generally places your least tax-efficient assets in your tax-advantaged accounts (like pre-tax 401(k)s), which already have big tax breaks, while diverting the most tax-efficient assets to your taxable accounts.

…And help you take care of the paperwork

You may be wondering: “Do I need to report 401(k) contributions?” The answer is “yes.” Specifically,  employees’ contributions must be reported on their Form W2, Wage and Tax Statement, and Form W-3, Transmittal of Wage & Tax Statement.

In addition, under the Employee Retirement Income Security Act of 1974 (ERISA), you are required to fulfill specific 401(k) plan reporting requirements, which include detailing employer and employee 401(k) contributions. While the paperwork can be complicated, an experienced 401(k) provider like Betterment can guide you through the process.

Take the next step

If you’re ready to get started, Betterment makes it easy for you to offer your employees a better 401(k) at a fraction of the cost of most providers.

As your full-service 401(k) partner, we can help you:

  • Design a plan with compelling features like automatic enrollment and employer contributions
  • Select and monitor plan investments (Betterment assumes full responsibility as a 3(38) investment manager)
  • Offer your employees personalized guidance to help them make strides toward their long- and short-term goals ranging from saving for retirement to paying down debt
  • Manage important compliance and reporting requirements

A Betterment 401(k) plan could be better for you—and better for your employees.

Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.