How to Set Up a Small Business 401(k): A Step-by-Step Guide

Key Takeaways

• Different types of 401(k) plans: The four main types of 401(k) plans - Traditional 401(k), Safe Harbor 401(k), Simple 401(k), and Roth 401(k). Each type has its own features and requirements, such as the use of vesting schedules, IRS discrimination tests, and employer contribution obligations.
• Investment options: A 401(k) offers various investment options, including mutual funds, stocks, bonds, and money market accounts. The account holder can choose the mix of investments based on their risk tolerance and financial goals.
• Tax benefits: 401(k) plans offer tax advantages, such as the ability to delay taxes on investment gains as long as the money stays in the account and receiving a tax deduction for contributions made to the plan. The Roth 401(k) option, however, requires paying taxes on contributions upfront but allows tax-free withdrawals in retirement.
• Employer contributions: Employers have the option to contribute to their employees' 401(k) accounts. They can choose to match the employee's contributions up to a certain percentage of their salary or provide a fixed contribution regardless of whether the employee contributes.
• Plan setup and management: Setting up a 401(k) for a small business involves various steps, such as selecting a provider, determining the plan details, writing the plan document, setting up a trust for plan assets, informing employees about the plan, managing record-keeping, and updating investments and rules as needed.

Setting up a small business 401(k) can offer many benefits for your organization. Not only do these plans help you and your employees save for retirement, but they may also help you recruit and retain employees.

If you've ever wondered how to start a 401(k) for your small business, this guide explains some of the different options on the market and how to get started. There may be other considerations beyond what's included here and you should work with a tax consultant or other financial professional as you determine what's right for your business.

Operating a 401(k)

The exact rules for your 401(k) will depend on the type you set up. All types tend to follow this general framework:

Investing in a 401(k)

When you have a 401(k) in place, you and your employees will be able to take money out of your paychecks and add it into the retirement plan. A 401(k) can offer a mix of investments like:

• Mutual funds
• Stocks
• Bonds
• Money market accounts

A 401(k) can also offer several tax features, such as:

• Delaying taxes on investment gains as long as the money stays in the 401(k)
• Receiving a tax deduction for adding money into the plan¹

Employee Matching Contributions

If you'd like to give your employees extra compensation, you can contribute to their 401(k)s. You could contribute to each employee's account, regardless of whether they put anything in the plan themselves. You could also set up a match and only give an employee money when they save themselves.

To help prevent turnover and reward loyal employees, you can set up your matching contributions with a vesting schedule, but depends on the type of 401(k):

• If your plan allows vesting, you can require employees to work for you for a minimum number of years before they can keep the matching contributions.
• If they leave before then, your company will get that money back.

There are limits on the minimum number of years you can require for vesting.²

IRS Requirements

Each year, your 401(k) plan will need to file Form 5500 to the IRS.³ This report shows how much you and your employees contributed to the plan. Depending on the type of 401(k), you may also need to run nondiscrimination tests to help ensure that you aren't paying too much to your highly compensated employees.⁴

If you fail to meet these IRS requirements, they could remove the tax benefits from your 401(k). To handle this work and help make sure your 401(k) is following the rules, you could hire a plan administrator.

Types of 401(k)s

Traditional 401(k)

A traditional 401(k) structure gives you flexibility because it's up to you whether you set up an employee match. You can also use vesting for your matching contributions, so employees need to work a minimum amount of time before they can keep your payments. There are limits on the minimum number of years that can be used for vesting. In exchange, a traditional 401(k) requires a bit of administrative work. You will need to run the IRS tests every year to help make sure the plan isn't overcompensating your top earners relative to the rest of your staff.

There is no limit to the number of employees who can enroll in a traditional 401(k). As of 2024, the most a person can contribute per year into a traditional 401(k) is $23,000 if they are younger than 50 and $30,500 per year if they are 50 and older.⁵

Safe Harbor 401(k)

The safe harbor 401(k) has simpler administrative work because you do not need to run the IRS discrimination tests each year.⁶ In exchange, you are required to set up employer contributions for your employees on this plan. The employer contributions cannot use a vesting schedule, so employees keep the money regardless of how long they work for you.

There are a few ways to comply with this employer contribution requirement. For example, you can give each employee 3% of their salary every year — regardless of whether they add money to the plan. Or you can offer a match to only employees who contribute, but the match must be dollar for dollar until the employee contributes 3% of their salary, and 50 cents for each dollar the employee contributes from 3% up to 5% of their salary. Finally, you could also choose to match all of their contributions up to 4% of their salary.

The safe harbor 401(k) does not have a limit to the number of employees who can use the plan and it has the same contribution limits as the traditional 401(k).

Simple 401(k)

The Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) 401(k) is another version for small business owners. The IRS states you can only use this plan if you have 100 or fewer employees.⁷ This plan has less administrative work because you do not need to run the IRS discrimination tests. Like the safe harbor 401(k), you are required to offer matching contributions to your employees, and you can't use vesting.

Your match can either be 2% of every employees' salary, regardless of whether they contribute or a dollar per dollar match only for employees who contribute, up to a maximum of 3% of their salary. The required matching contributions under the SIMPLE 401(k) are lower than the safe harbor 401(k), so this plan might end up being a little more affordable for some small business owners.

Roth 401(k)

The typical 401(k) offers an upfront tax break, where you and your employees get a tax deduction for your contributions. When you take money out in retirement, your withdrawals will be fully taxable, though.

Another possible approach is to use a Roth 401(k). In this system, instead of the upfront tax deduction, you pay taxes on your contributions as you make them. When you take money out in retirement, the withdrawals may be tax-free as long as the requirements are met for Roth accounts. This means that you or the employee won't owe taxes on the interest.

You can set up any of the versions of the 401(k) with a Roth structure. You can also offer both a traditional and Roth option, so employees can choose the tax benefit they prefer.

Setting Up a 401(k) for a Small Business

You've selected the optimal small business 401(k) for you, and you're ready to get started. Here are some of the next steps to consider:

1. Decide Who Will Launch the Plan

Will you launch the small business 401(k) on your own? Would you rather outsource the work? Banks, investment firms and insurance companies could all set up and maintain your retirement plan in exchange for a fee.

Running everything yourself will avoid the fee, but you'll be in charge of launching the plan and handling the future administrative work. Consider how much of your day-to-day operations can be delegated to other employees to make time for such an undertaking, and how that compares to the potential savings of doing everything in-house. The best strategy for you will depend in part on these factors.

2. Pick a 401(k) Provider

If you decided to use a 401(k) provider, you have your choice of candidates. To find the right fit, some features to look for include:

• Ease of use: Does the 401(k) provider's software look easy to use, both on your end for supervising the plan and for employees to manage their savings? Can it integrate with your existing payroll service to collect employee contributions?
• Fees: 401(k) fees can change drastically depending on the provider. Consider paying attention to the startup and administrative costs, and checking how much your employees will owe as well.
• Services offered: Does the 401(k) provider offer everything you're looking to outsource such as record keeping? If they're missing a key service, you may need to hire another firm for that job. It may be easier to take care of everything through one provider.
• Types of investments: Will the 401(k) provider allow all investments or only the ones they sell themselves? If you are looking for a specific fund or asset, consider making sure it's available with your provider.
• Employee education and support: Will your employees have the tools they need to effectively plan for retirement? See whether the 401(k) provider offers training materials or financial advice as part of their package.

3. Select the Type of 401(k) & Plan Details

Which type of 401(k) seems like the best fit for your business? You'll need to decide whether you want to:

• Offer employee matching contributions and how much
• Whether they would require vesting
• Which employees can use the plan (only full-time or everyone, etc.)
• Types of investments that will be available in the plan

Finally, you'll likely need to select an investment broker to provide the mutual funds and other investments for your 401(k).

4. Write the 401(k) Plan Document

The 401(k) plan document establishes all the rules for your small business retirement plan. If you outsource setting up the plan, your financial institution will probably write this for you. The plan document must meet all the 401(k) rules under the IRS code.⁸ If you aren't outsourcing the entire 401(k), consider hiring a benefit expert to at least review your plan document.

5. Set Up a Trust for Plan Assets

When employees invest through the 401(k), your business isn't supposed to have access to the money. Instead, it goes into a trust managed on behalf of everyone who contributed to the retirement plan. You'll likely need to open this trust before you can launch the 401(k).

6. Inform Your Employees

With the plan almost ready, you'll likely want to distribute the information to your employees so they know the plan details. These include:

• When they can sign up for the plan
• Whether they'll get a match
• What happens to their account if they leave the company

Employees will also need information on the different investment options.

7. Manage the Record Keeping

As you run the 401(k), you'll likely want to track how much employees contribute so you can report this information to the IRS at the end of the year. You may need to track how much is in the 401(k) overall. You can do this yourself using your payroll software because this shows how much employees withhold from their paychecks. You can also outsource to a 401(k) record keeping firm. If you hired a financial institution to run your plan, they'll most likely handle this for you.

8. Update Investments & Rules as Needed

You don't always have to stick to the same 401(k) approach. As your business needs change, you can update the 401(k) by adding new investments or increasing your employer match. Whenever you make a change, you'll likely want to share it with your employees.

The Bottom Line

Setting up a 401(k) for a small business can take some effort, but it may be worth it for you, your business and your employees. This guide can help get you started. If you have any questions along the way, consider reaching out to a financial representative.

Sources

1. 401(k) Plan Overview. https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview.
2. Retirement Topics - Vesting. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-vesting.
3. 401(k) Resource Guide - Plan Sponsors - Filing Requirements. https://www.irs.gov/retirement-plans/plan-sponsor/401k-resource-guide-plan-sponsors-filing-requirements.
4. 401(k) Plan Fix-It Guide - The plan failed the 401(k) ADP and ACP nondiscrimination tests. https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-the-plan-failed-the-401k-adp-and-acp-nondiscrimination-tests.
5. Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits.
6. Issue Snapshot - Compensation Definition in Safe Harbor 401(k) Plans. https://www.irs.gov/retirement-plans/compensation-definition-in-safe-harbor-401k-plans.
7. Choosing a Retirement Plan: SIMPLE 401(k) Plan. https://www.irs.gov/retirement-plans/choosing-a-retirement-plan-simple-401k-plan.
8. A Plan Sponsor’s Responsibilities. https://www.irs.gov/retirement-plans/plan-sponsor/a-plan-sponsors-responsibilities.