There are a host of federal tax incentives for starting and maintaining retirement plans
by Tom Foster
Mr. Foster is Assistant Vice President, Strategy and Relationships for retirement plans for Massachusetts Mutual Life Insurance Co. (MassMutual). Visit massmutual.comNovember 3, 2016 — U.S. Sen. Russel B. Long of Louisiana, chairman of the powerful tax-writing Senate Finance Committee from 1966-‘81, once summed up Americans’ sentiments about tax policy: “Don’t’ tax you, don’t tax me, tax that fellow behind the tree.”
Despite his populist inclinations, Long was also champion of tax breaks for businesses, stating that, “you’re going to have to have capital if you’re going to have capitalism.” The Senator from the Bayou State was instrumental in helping pass the 1986 Tax Reform Act, which laid the foundation for today’s tax treatment of 401(k)s and other defined contribution plans.
The federal income tax code continues to offer incentives to make it more affordable for businesses to implement 401(k)s and other defined contribution retirement plans. Once a retirement savings plan is in place, there may be additional tax breaks to save and invest, not just for employees, but for business owners as well. Few endeavors receive as much encouragement from the IRS as setting up and contributing to a retirement savings plan.
Small Employers Unaware
Astoundingly, many small employers are unaware of the available tax incentives. They mistakenly identify with Sen. Long’s “fellow behind the tree.” They remain unaware of the valuable tax benefits that can help defray the cost of establishing a retirement plan; reduce the taxable income for the business, the business owner and employees; and allow them to defer taxation on gains associated with retirement savings.
The lack of knowledge is an impediment to the formation of 401(k)s. Only 14 percent of employers with fewer than 100 employees sponsor a retirement plan, the U.S. Government General Accountability Office (GAO) reports1, many because they lack the financial resources to do so. It’s a huge barrier to America’s retirement security considering that approximately 42 million workers – about one-third of all private-sector employees – work for smaller companies, according to the GAO.
Knowledgeable financial advisors can perform a great service to small businesses and their employees by working closely with legal and tax advisors to help educate small-business owners on the available tax advantages of establishing a retirement plan:
Retirement Plans Startup Costs Tax Credit
Employers may be able to claim a tax credit for 50 percent of the ordinary and necessary eligible start-up costs for qualified retirement plan such as a 401(k) up to a maximum of $500 per year for up to three years. The credit, which also applies to SEP and SIMPLE IRAs, reduces the amount of taxes an employer may owe on a dollar-for-dollar basis.
To qualify for the credit, employers must have 100 or fewer employees who received at least $5,000 in compensation from their company for the preceding year, had at least one plan participant who was a non-highly compensated employee, and the company’s employees were not substantially the same employees who received contributions or accrued benefits in another plan sponsored by the employer in the last three tax years before becoming eligible for the credit.
Reduction of Current Taxable Income
Employees who participate in an employer-sponsored retirement plan – including the business owner – can defer up to $18,000 of their income annually. Those who are age 50 or older can defer an additional $6,000 annually. Deferrals or contributions reduce the employees’ taxable incomes and may therefore lower their overall federal income-tax bills.
While many small-business owners establish retirement savings plans to compete in the marketplace for talent, the primary reason is often the opportunity to accumulate retirement savings on their own behalf. Contributions to a retirement plan participant’s account – both by the employee and the employer – can total the lesser of 100 percent of the participant’s compensation or $53,000. The limit is $59,000 for those age 50 or older.
Those higher contribution limits make 401(k)s highly attractive for many business owners who need to save significant amounts to continue their lifestyles in retirement. Taking advantage of the ability to contribute savings on a pre-tax basis makes doing so more affordable.
Employer Contributions Are Deductible
Contributions to a retirement plan by employers on behalf of employees are tax-deductible. Four in five (81.8 percent) of 401(k) and combination plans match participant contributions and 55.4 percent of firms provide a non-matching contribution, according 2014 data from the Plan Sponsor Council of America2, the latest available.
The deduction for contributions to a defined contribution plan cannot be more than 25 percent of the compensation paid (or accrued) during the year to the eligible employees participating in the plan. Those who are self-employed (business owners) must reduce the limit in figuring the deduction for contributions made on behalf of their own account as an ordinary and necessary business expense. And what could be more necessary than a business owner’s retirement savings?
Deferral of Gains
Contributions and investment gains made to a 401(k) or other qualified retirement plan are not taxed until they are distributed, typically at retirement. The deferral of taxation on gains may help accelerate the compounding of savings, especially over many years.
According to an example provided by the IRS, a $500 monthly contribution to a retirement plan growing at 6 percent annually on a tax-deferred basis would accumulate to $35,059 in five years, $146,136 in 15 years and $232,176 in 20 years. Yet, $500 a month amounts to $6,000 annually. The value of the account – and the tax benefits — increases dramatically if the plan participant contributes the $18,000 maximum.
A Capital Idea
It’s a good bet that many of the small-business owners in your area are so busy making widgets, serving their customers or putting out fires that they may have overlooked the latest tax incentives for starting and maintaining a 401(k) plan. It’s up to you to raise the issue and help ensure they understand the available benefits.
Sen. Long and his successors in Congress have gone to great lengths to encourage capital formation in retirement plans. When it comes to saving for retirement, there are plenty of tax incentives to go around, including for you, for me and that fellow behind the tree.◊
Great article… As a small business owner, Mr Fosters article was very informative. He was spot on… I’ve been counting widgets , serving customers – and my favorite.. putting out fires (for the past 25 years). I really overlooked the benefits of exercising the benefits available with my 401k.. Well written – thank you.