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The IRS doesn't want startups to offer 401(k) plans

Why it's hard to offer retirement plans and what you can do about it

Welcome to Spots, where I share what I’m learning about startups, tech, and how our industry operates.

Courtesy of ChatGPT

For many, working in tech is synonymous with getting lavish company perks, from the more serious 100% employer-paid healthcare premiums to the slightly absurd in-house masseuses1 .

In reality, that’s not the case for folks at early-stage tech companies. Most recognize that working at a young company means forgoing cash compensation in exchange for the potential value of their stock options. But for those moving from big corporations or later-stage startups, the lack of other basic benefits such as healthcare2 is a surprise.

Nobody is expecting free lunches on the daily, but benefits that are often taken for granted like healthcare or commuter benefits are also often missing from these companies.

Sidenote: if anyone knows of a dataset that shows benefits offered at various stages of tech companies, I’d love to see it. I looked for quite some time and couldn’t find anything!

For most of these, it’s obvious why they aren’t offered - they are expensive, and not a good use of the startup’s limited cash. They are also an operational headache to set up, especially for a small team with limited bandwidth. However, there’s one missing benefit that should be offered more often: 401(k) plans.

Theoretically, offering access to a 401(k) without any employer contributions would have zero, or negligible, cost to the employer. So why don’t more startups do it? Because the IRS makes it difficult to do so.

Also ChatGPT. I love how it struggles with text.

For those who haven’t spent hours thinking about this, here’s a quick primer on 401(k) plans first:

A 401(k) plan is a retirement savings plan sponsored by employers that allows employees to save and invest a portion of their paycheck before taxes are taken out. It offers tax advantages, such as deferred taxes on earnings and contributions, and often includes employer matching contributions, enhancing the employee's retirement savings.

Because the 401(k) has so many benefits, the IRS wants to make sure that 401(k) plans aren’t tax shelter vehicles for the company’s highly compensated individuals. A tax shelter with a $23k annual limit feels like small fish for the IRS to be frying, but I digress.

From a public policy standpoint, the IRS wants to ensure that equal access to saving for retirement for employees at all pay grades, and to encourage employers to kick in.

To achieve this, the IRS administers a series of tests on 401(k) plans. These tests are designed to test whether your plan unfairly benefits two different classes of employees: highly compensated employees and key employees (including owners).

  1. Non-Discrimination Tests: These ensure that the plan does not favor highly compensated employees (earning over $150,000 per year) over non-highly compensated employees. Tests compare the contributions of these two classes of employees to ensure it is not heavily weighted in the favor of highly compensated earners.

  2. Top-Heavy Test: This test checks if the plan is "top-heavy," meaning a disproportionate amount of plan assets are held by key employees (typically owners and officers). If a plan is top-heavy, it must make minimum contributions for non-key employees. Ownership is defined as owning at least 5% of the company, or being a highly-compensated employee and owning at least 1% of the company.

  3. Coverage Test: This test evaluates whether a sufficient percentage of non highly compensated employees are covered by the plan, ensuring the plan benefits a broad employee base and not just select groups.

Beyond involving a fair amount of work to monitor, adjust, and report compliance here, complying with these requirements can be particularly challenging for startups.

  • High proportion of highly compensated employees: Tech salaries are high, and even at early stage companies, it is likely there are many employees earning over $150,000.

  • Equity compensation isn’t factored in: For employees who opt for a larger chunk of equity over a bigger salary, they will show up as “non highly compensated earners.” These employees likely wouldn’t contribute to a plan if offered, as they have taken an intentionally reduced salary.

  • Small samples are easy to skew: Because companies at this stage are quite small, just one or two people changing their behavior is enough to cause issues with these tests and make startups have to adjust their thresholds frequently.

That’s a lot to keep track of. And you know who rightfully wants to avoid overhead? Early-stage tech startups. They’re in survival mode - trying to scrape their way to product-market fit. The last thing anyone wants to do is squint at a spreadsheet trying to figure out if they’re in compliance with the IRS.

But wait, those of you savvy about 401(k) plans will say - what about Safe Harbor plans? Safe Harbor plans are essentially a way for companies to avoid being subject to discrimination testing by contributing a minimum match to their employees’ 401(k) accounts.

These plans are absolutely a way to avoid the headache of monitoring compliance, but it means the company is contributing to the 401(k). Anyone who is an equity holder (including the employees with options) should view that as a pretty silly way to spend the limited capital the company just raised.

Up until very, very recently, startups were left with two options: offer access to a traditional 401(k) without any employer contributions and monitor for IRS compliance, or don’t offer one at all.

Essentially, the IRS requirements to prevent abuse and promote equal access to 401(k)s result in less employees having access, since most early stage startups simply opt out of offering retirement planning entirely.

These are arguably worse outcomes than if the IRS relaxed their requirements and some % of startups then unfairly implemented 401(k) plans. Employees with children or who are older might not feel comfortable deferring their ability to contribute to the tax-advantaged 401(k), which means they won’t take the leap to work in startups. This is one of many factors that leads to an employee population that skews young and well-off, which means the population building new technology for everyone doesn’t look like everyone.

In my ideal world, businesses who meet certain criteria3 would be able to implement a traditional 401(k), with no match, without the testing requirements from the IRS. Early-stage employees who want access to a 401(k) could contribute as low as 1%, and contribute up to the full maximum allowed ($23,000 for 2024). For a ten person company, this only would cost around $2000 per year.4

So, short of waiting for legislative reform, what’s a founder to do? Here’s what I’d recommend for founders in this situation - wanting to give employees options for tax-advantaged retirement savings, but not willing or able to implement a traditional plan.

  1. Make sure employees are aware of their ability to open an IRA, and see if they are maxing that out first ($7,000 for 2024). You can’t fact check this, but with small teams there should be high enough trust to get honesty here.

  2. The next thing to look at is brand new for 2024: Starter 401(k) plans. This gets part of the way there, as these plans feature limited compliance requirements, partially because it doesn’t allow employer contributions. I am really excited that this is happening this year! But, it has some serious constraints: it has a $6k max for 2024 (lower than the max for an IRA, and only a quarter of the 401(k) max), and employees have to contribute at least 3%.

I’m heartened by the Starter 401(k) plans introduced by the SECURE 2.0 Act, as they address some of the core problems outlined here.

Over time, I hope to see the maximum increase for the Starter 401(k), and get closer to matching the maximum for a traditional 401(k). Working at startups is a risk for your current and near-term livelihood - it shouldn’t also mean you aren’t able to plan for your retirement.

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1: and ZIRP-y

2: I often say that spouses with healthcare are the underappreciated “angel investors” of entrepreneurs . Thanks to my husband for his healthcare :)

3: I’m not the public policy wonk, I’ll leave that to my husband

4: Based on Guideline, a popular 401(k) provider for tech companies

Some of the sources I consulted:

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