How 401(k)s help small teams stretch their compensation budget

Claire Baker
Jun 20, 2023
7 min read

Updated: Jun 22, 2023

Two out of three workers in the US have access to a company-sponsored 401(k) plan, making 401(k)s the most common way to save for retirement.

The tax structure of 401(k) plans help participants make more from their income over their lifetime. Adding a 401(k) plan to a company’s benefits package also gives businesses a less expensive way to compensate employees than adding the same amount to base compensation.

What are 401(k)s and why do they exist?

Prior to the 1980’s, most retirement plans were pensions controlled by the company. Pensions required a great deal of administrative overhead and managing a large quantity of assets over many decades, making pensions viable only for businesses with the scale to support them. Pensions weren’t ideal for some employees either, since they made it difficult to change jobs, and not all businesses could afford to offer pension plans. As labor trends changed, there was a need for a different model to facilitate retirement savings and give individual employees more agency in their own retirement planning.

Traditional 401(k)s were introduced in the 1980’s as a way for employers to reduce the cost and overhead of retirement programs, and to help employees leverage the stock market to gain control of their retirement savings.

In a traditional 401(k), an employee sets aside a portion of their income before taxes in an account that they won’t touch until they reach retirement age. Since the money is invested before tax, participants can invest roughly 30% more into the account than if the same proportion of their income were invested after taxes. When an employee reaches retirement age, their withdrawals are taxed as income, but the capital gains tax does not apply.

In 2006, ROTH 401(k)s became available, allowing employees to invest post-tax money into eligible accounts. Since taxes have already been withheld from ROTH funds, post-retirement withdrawals are tax-free.

Although each post-tax ROTH contribution is smaller than its traditional counterpart, the same amount withdrawn from a ROTH after retirement can last 20% longer (or more!) than a traditional plan.

The tax savings of Traditional and ROTH 401(k) plans compound over time. This chart assumes a 24% federal income tax rate and does not take state taxes into account.

* Traditional 401(k)s (blue) will be taxed as income upon withdrawal, a relative adjustment not reflected on this chart. ROTH contributions (red) assume a 24% income tax rate is applied to contributions. * Non-401(k) balances assume a 24% federal income tax rate at time of investment, and 24% federal income tax rate + 10% capitol gains tax at withdrawal.

Depending on your retirement lifestyle, saving through a 401k gives an employee more control over:

💰 how much of their salary is invested in a retirement account,
📈 what funds their retirement savings are invested in,
💸 how their retirement savings are taxed.

The only drawback of 401(k) plans for the employee is that if they withdraw before legal retirement age, then they must pay their regular tax rate (if they haven’t already through a ROTH) plus a 10% penalty on those funds.

What’s in it for the employer?

Employers also benefit from the tax and administrative savings of 401(k) programs. Administrative costs and matching contributions can be claimed as a business expense, lowering the company’s overall tax liability rather than adding to it as payroll taxes do.

The administrative costs of a 401(k) are negligible; only a few dollars per employee per month in most cases, making offering a 401(k) program as a no-brainer for even cash-strapped organizations. Although matching is not required, a company can significantly lower their tax burden by funding employees’ accounts, either through a matching program or non-matching contributions. Win-win!

A strategic 401(k) matching program can also stretch a company’s compensation budget farther in three ways:

Employees keep more of their money: The tax savings allow traditional 401(k) participants to keep roughly 30% more of their income provided they don’t touch it until they retire. The tax savings of a ROTH plan mean that employees don’t need to factor in taxes in their post-retirement budget. The tax savings alone can net the employee hundreds of thousands of dollars over their lifetime.
Count matches as part of overall comp: Compensating an employee through a company match (or unmatched employer contribution) means that the employee gets to keep many times that amount over their lifetime. Compare that to the diminished post-tax amount they would receive if they were paid the same amount as part of their salary.
Money on the table = money in the company’s pocket: While all employees cash their paychecks, few employees max out their 401(k)s each year. When employees don’t max out their match, employers keep those funds in their pocket while still reaping the recruiting and retention benefits of a generous 401(k) match.

Let’s consider some examples of how including your 401(k) in your overall compensation planning and budget benefits both employees and the business alike.

Example 1: Employee ROI

Both employer and employee must pay tax on an employee’s base compensation. This means that for every dollar spent as base salary, the employer pays slightly more than $1 and the employee receives significantly less than $1.

However, if the same compensation were made through a 401(k) match, the employer does not pay payroll tax on the employee contribution, receives a tax write-off for the contribution itself (lowering overall tax burden), and more of the money goes into the employee’s pocket. In other words, for every dollar contributed to employees’ 401(k)s, the business spends slightly less than $1 and the employee receives many dollars after retirement.

As an example, a $6000 per year raise is unlikely to significantly change an employee’s quality of life, but a $6000/year company match seems quite generous. The chart below shows the relative employer costs and employee returns on $6000 paid through a 401(k) match or regular compensation.

Amounts based on a 24% income tax bracket, and a 7% rate of return on a single $6000 contribution after 20 years of compound interest.

Since a 401(k) match is more cost-effective and emotionally impactful than a pure salary hike, company matches are a more cost-effective way to compensate employees. For this reason, many employers invest in 401(k) matching programs as part of their overall compensation strategy.

Example 2: Budget comparison

Imagine your small business has room in the compensation budget to offer a $500/month raise to all 25 employees. How much would it cost the company to add $500/month to its employees’ base salary vs. to their 401(k) accounts?

Base compensation total cost: $161,475

($500/month * 25 employees * 12 months) + 7.65% payroll tax = $161,475

Of the $161,475 that the company pays, employees only net a cumulative $114,000 or $4,560 each (not counting state and local taxes).

Employees and employer together pay a cumulative $47,500 in federal taxes, not counting additional state and local taxes.

ROI: Only 70.6% of the company’s investment goes to the employee. 401(k) match total cost: less than $118,500

($500/month * 25 employees * 12 months) – 21% corporate income tax = $118,500 Since company contributions are untaxed, there are no additional costs beyond the match itself. Of the $150,00 that the company pays, employees net the same amount, plus interest. Since the company can write off the match as a business expense, they are not obligated to pay the 21% corporation tax on the amount of the match. In other words, it only costs the company $118,000 to pay its team $150,000.

ROI: 127% of the company’s investment goes to employees.

But wait, there’s more! Not all employees will max out their employer match on their 401(k), leaving whatever funds aren’t claimed by employees in the employer’s pocket. Assume that the average employee contribution at the company above is $300 per person per month.

($300/month * 25 employees * 12 months) – 21% corporate income tax = $71,100

Although the company may have allocated $150,000 for the matching program, with a 3/5 usage and the tax benefits, the company could save more than half the budget.

Meanwhile, thanks to compound interest, an employee investing at the company average rate of $300 per month could receive many multiples of that by the time they reach retirement age. Assuming the average employee retires in 20 years, after a 7% rate of return an employee that receives a $300/month match would collect more than $23,000 at retirement.

($300/month * 12 months) = $6000 $6000 compounded annually @7% interest = $23,218

ROI: 387% of the company’s investment goes to the employee. By offering the same amount of money through a 401(k) match, the company saves roughly 56% of their additional compensation budget (assuming 3/5 participation). After 20 years, a match will pay the employee approximately five times what they would collect if they were paid same amount as salary.

Messaging

In addition to the overall cost savings of compensating your team through a 401(k) match rather than base compensation, employers can leverage the benefits of a generous 401(k) program to support recruiting and retention. Although a comparable amount invested in salary is unlikely to move the needle on headcount, employers who effectively message the employee’s upside of this program can attract and retain talent at a fraction of the price.

Here are some tips for messaging related to your 401(k) program in your employee-facing materials:

Talk about the employer 401(k) contributions as part of the company’s overall compensation package (not just as one of its benefits and perks).
Explain the reasoning behind the program as a desire for your employees to prosper throughout their lives from the time they spent at your company.
Discuss the 401(k) program as a tool to support employees’ financial health by giving them a way to reduce their tax burden now and when they retire.
Show deference to how difficult it can be to save, and position the matching program as a way to put comfortable retirement within reach for all of your employees.
Keep in mind that employees from underprivileged backgrounds often have more financial obligations that make it harder for them to save for retirement. If DEI is a strategic priority for your company, you can use your 401(k) program in your overall strategy to support team members from diverse backgrounds and circumstances.

In the next post, we'll discuss the practical steps for managing a 401k plan, and compliance regulations that employers should know when administering their plan.

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