If your company is considering a 401(k) plan or already has one, you may be curious how your 401(k) can be optimized to minimize accounting and tax headaches. Understanding your options regarding employee deferrals, employer contributions, and administrative fees, can help manage business expenses more predictably.
Employee deferrals are the foundation of 401(k) plans, allowing employees to contribute to a tax-advantaged 401(k) account directly from each paycheck earned from the sponsoring employer. When payroll is processed, 401(k) deferrals are deducted from employee paychecks and the employee’s net check is paid out to them. The entire paycheck amount is deducted from employer books as a wage expense. The amount of the 401(k) deduction is recorded as a liability, which is tracked in an account often called “401(k) payable” or similar.
When 401(k) deductions are remitted to the 401(k) trust account from the employer’s liability account, the liability is reduced to $0.
Practice Tip: When preparing your business tax return, you will report the full gross wage expense not reduced by any employee 401(k) deferrals. (I.e.You paid your employees wages but they chose to defer a portion of those wages into the 401(k). However, you still get a deduction for the full wage expense.)
Taxes on Employee Deferrals
Traditional pre-tax 401(k) deferrals are not subject to Federal income tax (while Roth contributions are. Most states and municipalities (though not all) exclude traditional 401(k) deferrals from taxation and withholding.
However, both pre-tax and Roth (after-tax) deferrals are subject to Federal Social Security and Medicare taxes as well as State Disability Insurance, such as California SDI. Check with your payroll provider or tax advisor if you have questions about how your jurisdiction's tax rules apply to 401(k) withholding and taxation.
Pretax and Roth 401(k) contributions will be reported to employees in Box 12 of their W-2s.
If you make pretax contributions, they will be taxable on distribution while your Roth deferrals will generally not be subject to tax on distribution.
Employer contributions made during the fiscal year
Employer matching or nonelective contributions are deducted as an expense (separate from wages) each payroll period when you process payroll. Like employee deferrals, these amounts are listed as a liability until they are remitted to your 401(k) plan. Generally, these amounts are remitted directly from your operating account at the same time employee deferrals are remitted to the plan trust. When amounts are collected from the employer's operating account,the employer contribution liability is reduced to $0. The company may deduct the total expense amount on its business tax return.
Employer contributions made after the fiscal year
Profit Sharing contributions made after year’s end are deductible on your prior year’s tax return so long as the contributions are made before you file your tax return. How you record your profit sharing expense will depend on your company’s accounting practices. You can either use a liability account or a separate tax adjustment). With either method, you must ensure that the expense is deducted in only one tax filing year.
If your plan has employer matching calculated on an annualized basis, you will need to make true-up contributions to any employees who did not receive their full match amounts over the course of the year. Like profit sharing, true-up amounts are deductible in the previous year, even though they are made after the year end.
Taxes on Employer Contributions
Employer 401(k) contributions are made on a pretax basis and are not subject Federal Income Tax, Social Security, Medicare or other payroll taxes when made. In almost all instances, 401(k) employer contributions will also be deductible expenses for the employer.
Plan Fees and Expenses
Plan-related fees and expenses are recorded as a separate expense from employer contributions. These fees can be deducted as a general business expense. Certain employers may also qualify for a plan startup tax credit, up to a maximum of $500 per year. Learn more here.
Separately recording fees and expenses paid outside of the 401(k) account allows for more transparent tracking for reporting purposes. Contact us here at Guideline for more information on starting a new Guideline 401(k) plan or if you have any questions about our services!