Setting up a 401(k) & profit-sharing plan for small businesses

As a small business owner, you are constantly thinking of how to reinvest in your company to make it more successful, create stability, and keep employees happy and engaged.

One way to do this is to focus on their financial well-being and investing in their retirement. You can do this by creating a 401(k) and profit-sharing plan that will invest in your own future to save up to $67,500 a year for your own retirement, which may allow you to save up to $24,975 in federal taxes and help your employees’ future retirement. 

A combination 401(k) and profit-sharing plan 

A 401(k) and profit-sharing plan are two separate plans that can be combined to increase contribution amounts that are established by ERISA (The Employee Retirement Income Security Act of 1974).

This Federal law provides rules for how companies set up contributions and sets minimum standards for participation, vesting, and funding for retirement benefits for themselves and their employees.

401(k) and profit-sharing plans can be complex and have a lot of rules, so it is important to have the right financial team in place to help you make good financial decisions. This team should involve your CPA, financial advisor, third party administrator (TPA) and recordkeeper. There is a long list of services that each service provider may offer your company, but here is a short list. 

• Your CPA helps provide you insights into the tax benefits of setting up and funding a 401(k) plan and helps create a budget for your total contribution amount based on your net income. 
• A financial advisor typically helps select options for the TPA and recordkeeper based on the 401(k) plan size, contribution amounts and technology requirements and helps provide investment product recommendations. 
• The TPA helps the owner review options for plan design, contribution and matching formula and completes the annual compliance and filing requirements. 
• The recordkeeper is the company that receives the contributions and shows all of the participants their balances.  

Contribution Limits

401(k) Contribution limits

The employee elective contribution limit within the 401(k) plan for each employee is $20,500 in 2022, plus a catch-up contribution of $6,500 for participants that are 50 years old or over.   

Profit-sharing Contribution limits

The company can also make contributions for each participant, which includes the owners, that are considered “profit-sharing contributions”. ERISA provides the total contribution limits each year, and in 2022 the total contribution limit for participants under 50 is $61,000 (this includes the $20,500 employee contribution and the employer profit-sharing contribution of $40,500). For participants, including owners of the company that are 50 years old and over, the total contribution limit is $67,500 (including their employee contribution of $20,500 plus the catchup contribution of $6,500 and profit-sharing contribution of $40,500). 

Tax Considerations     

I like to think of retirement plans as a way to decrease their top taxable earnings, especially when they are able to make significant contributions. For example, let’s assume a business owner, who files as single, makes a combination of salary and net income from their business of $575,000. If they were to set up and make the full contribution of $67,500 in 2022, they would reduce their taxable income from $575,000 to $507,500. Taxable income of $575,000 would put them in the 37% federal tax bracket, but by making the full $67,500 contribution, their income would drop down to $507,500 in taxable income and they would be in the 35% taxable income bracket. The contribution would save $24,975 ($67,500 x 37%) in federal taxes. You can also do a similar calculation for your respective state income taxes to do a full tax benefit calculation.

Related: 5 financial wellness benefits small businesses should consider offering

For a married couple who are owners of a company and 50 years old or more, they can make a max contribution of $67,500 each for a total contribution of $135,000 for 2022. If we assume they are also in the 37% Federal tax bracket, they would save a combined $49,950 in federal taxes by making the 401(k) and profit-sharing contribution.

Cost Benefit Analysis

Owner contributions vs participant contributions cost benefit analysis

Business owners will need to work with their TPA to determine how much they want to contribute for their own retirement plan and then the minimum requirement they will need to contribute for their employees. The business owner will want to calculate the tax savings of their retirement contributions and compare with the employee contributions plus plan costs to calculate the cost benefit analysis. The cost benefit amount does not have to be positive in favor of the business owner, but it’s important to understand the benefit formula and net costs of the plan.

Establishing a 401(k) and profit-sharing plan can be a powerful tool to help you save for retirement, decrease your taxes, attract and retain top talent, and help your employees save for retirement. 401(k) plans are complicated, so it is important to have the right financial team in place that are providing suggestions based on your personal contribution goals, company contribution cash flow budget, and employee contribution goals. 

Halbert Hargrove Global Advisors, LLC is an SEC registered investment adviser located in Long Beach, California.