So you are a startup founder who has grown to the point where you want to set up a 401k for your employees. That is awesome! It means that you are moving ahead in the startup journey and are attracting the type of employees who are thoughtful enough to plan for their retirement.
I’m the VP of Financial Strategy here at Kruze Consulting, a leading CPA serving hundreds of VC backed startups who raise billions of dollars annually. I’m also a former exec at a 401k provider, so have some seriously strong opinions on what to look for in a 401k.
Kruze is not a 401k advisor - that term has a specific legal meaning. However, we are accounting, payroll and tax advisors to many startups, and get asked a number of recurring questions about retirement plans.
Let’s dive into the subjects we regularly get asked about; how to pick a provider, what to look for, who are the best providers to VC-backed startups, and what about that 401k tax credit?
What to look for in a startup 401k provider
Low administration burden. You as a founder don’t want to be spending a lot of time administering a 401k. 401ks are complicated and highly regulated; running a startup is time-consuming enough without adding the burden of administering a complex retirement plan. Seek out a provider with robust automation capabilities. For instance, if an employee adjusts their savings rate from 4% to 8%, this change should automatically sync with your payroll system without necessitating manual updates.
User-Friendly An ideal retirement plan provider offers a streamlined, digital-first experience. It should allow employees to register, make choices, and adjust their settings online, bypassing the need for traditional paperwork. Faxing is a big NO.
Solid compliance. 401ks are highly regulated, so there is serious government paperwork. You want a provider who can produce this paperwork for you - some will even sign it for you. The IRS is trying to regulate away employers who steal the retirement contributions - as a consequence the paperwork is legit. Good providers take care of this.
Encourage participation. Your chosen provider should promote and facilitate employee participation. This is done through UX, automation and good marketing. A crucial aspect of retirement plan regulations, called ‘non-discrimination testing,’ aims to ensure lower-income individuals are participating, with penalties for non-compliance. Select providers who encourage high participation levels to avoid potential savings limitations for employees earning above a specific threshold (e.g., $135K in 2022). Failing non-discrimination tests is VERY painful.
Cost. Thanks to technology, there are now good, low-cost 401k providers. Retirement plans come with fees, often divided between employers and employees. Be wary of providers charging suspiciously low company fees, as the employees might be paying for it through inflated investment fees. A balance must be struck here.
Investment Options: A good 401k plan should provide a wide array of investment options, including index funds, target-date funds, mutual funds, bond funds, etc.. Look for low cost, passive funds as a default option. Keep in mind that Vanguard’s target date funds are 8 bps - 0.08% of assets - that’s a low fee.
Investment Fiduciary responsibility: Did I mention that this is a regulated space? It is. And, as a company offering a 401k, you have regulated fiduciary responsibilities. The investment fiduciary is responsible for choosing and managing the investments available to your employees. You need to outsource this responsibility - do not take it on yourself. There are two primary fiduciary options, make sure your provider is doing one of these, hopefully the 3(38):
ERISA 3(38) Fiduciary: This fiduciary makes independent investment decisions without needing the plan sponsor’s approval for each decision, including selecting and managing the investment lineup. This approach offers more protection and less hands-on time for startup founders.
ERISA 3(21) Fiduciary: In contrast, a 3(21) fiduciary shares investment decision responsibilities with the plan sponsor. While this gives the employer more control, it also carries more liability. It’s probably not worth it for most startups, unless you are a wealth management startup.
So here at Kruze we get asked by a number of founders who we would recommend that they choose to administer a 401k for their startup. As a former executive at a 401k provider, I have some pretty strong opinions. And our opinions may change; we’ll keep this comparison section updated.
Automated 401k provider vs manual
You can either use an automated provider or a manual vendor. Automated means that you, as the company founder, don’t have to do a lot of logging in and button pushing when an employee joins or changes the percent that they want to save.
If you really want to save money, you can go with a manual vendor. They will usually be the cheapest but it takes manual labor to keep it going. I don’t recommend it. Startups will only save a few hundred dollars a year, max, and the time the founder will waste isn’t worth the return. But, if you really want to save money, there are two solid options - Vanguard or a company called Employee Fiduciary. They are going to be very low cost, but it’s going to take some effort on your part.
Going directly with your payroll provider’s preferred vendor, or going with an automated provider, will make a lot more sense. The leading providers here are Guideline, Human Interest, maybe Betterment depending on your payroll provider. Justworks and Trinet have decent automated 401k providers as well. The support at the automated providers wasn’t historically that great, although I’ve heard that it’s getting better. And the costs are usually quite reasonable.
Startup 401k provider comparisons - 2023
Don’t forget to look for a provider who will be an investment fiduciary.
Check out our video on what to look for in a startup 401k provider to learn more about what to look for in a 401k vendor for your startup.
Is there a tax credit for startups that start a 401k plan?
Yes, but this tax credit is for companies that are making a profit - it’s a credit that reduces the income tax that your company pays. Unprofitable companies - which most VC-backed companies are - won’t benefit from this credit.
The 401k tax credit, introduced by the SECURE Act, can be beneficial to tax income-generating startups to offset the costs of setting up a new retirement plan. There are several requirements that need to be met to get a credit, including a max number of employees, minimum pay requirements for those employees, and more. Learn about the 401k tax credit here.
The benefits of offering a 401k plan
Getting a retirement plan going for your startup is a pretty smart move, and it’s not just for those bigger, public tech companies like Google or Salesforce. Even if you’re running on venture capital, you can roll out a retirement plan (without having to match contributions, which is what most of the big boys do).
Why is a 401k a good perk for your employees?
Here’s the deal: When your employees stash their cash in a traditional 401k, they don’t have to fork over taxes on it right away. This means more money in their retirement accounts to grow and work for them over time. If an employee, fresh out of college at 22, starts putting money into a 401k, imagine how that money will grow, tax-free, for the next 30 or 40 years! Yes, they’ll pay taxes when they start taking money out, but the benefit of all that compound growth on a bigger base can’t be beat.
And the good news for your team doesn’t stop there. Every dollar they put into their 401k is pre-tax, which means they lower their taxable income for the current year. So, if someone earns $100,000 and puts $15,000 into the 401k, their taxable income drops to $85,000.
Once your startup has enough funding, consider getting a 401k plan going. There are plenty of providers out there, but the key is to pick one that plays well with your payroll system and has neat and tidy reporting for your CPA team. Having a 401k can be a big win for your employees, and it doesn’t have to cost an arm and a leg for your startup. It’s a win-win.
Common Startup 401k mistakes
Every year, we see founders stumble into the same mistakes with their startup’s 401k. Here are some of the most common issues that startups make with their 401k.
The IRS and Department of Labor don’t want your retirement plan to only benefit the highest paid employees - basically, some small business owners tried to use retirement plans as a way to shield themselves from taxes, while not offering the plan to their employees. So the IRS came up with a series of tests, called “non-discrimination testing,” to make sure that all employees are saving into the plan. When these tests are failed, the highly compensated employees usually have some of their contributions clawed back, and the startup sponsoring the plan likely has to deal with some nasty paperwork and fees/fines to fix everything.
For a VC-backed startup, the main issue we see is when the highly-compensated developers, sales people, etc. contribute to the plan but lesser-paid employees don’t. For these purposes, in the year 2022, the IRS defines highly-compensated as people making over $135,000 per year or owning a meaningful percentage of the company. This is a very common issue - so encourage your lesser-paid employees to use the plan! Talk with your 401k provider about tips and design elements that can help you help them.
You can also set up what is called a “safe harbor” plan, where the company contributes to the retirement savings at a set percentage, to get around this testing.
Trying to make macro changes to the plan mid-year
The IRS limits the times that the company can change the plan. Basically, before the beginning of the retirement plan year, your provider should help you put together a document that outlines the rules and features of the plan. This gets set for the plan’s entire year; you can’t make major changes to this. So if you are going to cut costs by eliminating your plan or reducing the employer contribution, make sure you have thought about it at the right times of the year.
Not talking with the 401k provider before switching payroll providers
If you are working with an automated retirement plan vendor, they need to know ahead of time if you are going to switch payroll companies. Don’t forget to give them enough time to switch over!
Picking a provider that charges employees too much
401k pricing is notoriously difficult to fully understand. Part of the costs are baked into a fee charged to employees as a percentage of their assets. It’s not only the provider who charges fees; the funds also have management fees. When evaluating providers, and the investments they recommend, ask for a fully loaded cost to the employees, to the company, and together.
Failing to delegate fiduciary responsibilities
As a startup founder, you have numerous responsibilities. Picking the investments, documenting why you’ve picked the investments, monitoring the investments - if you don’t delegate this responsibility, it’s yours. Not delegating these duties to an ERISA 3(38) or 3(21) fiduciary can lead to poor investment choices and increased legal liability. And a ton of work. You aren’t running a hedge fund, and the provides we recommend will pick this up for a small fee. Don’t take it on yourself.