Understanding the tax credits available to newly established retirement plans
by: Brian Kane, CPC, QPA, QKA
If you have recently implemented a 401(k) or other qualified plan, you may be eligible for significant tax credits that can cover most, or even all, of your plan costs for the first few years of the plan. Plans already in existence may also be eligible for a credit if they are adding a new eligible automatic enrollment feature.
The Retirement Plan Startup Costs Tax Credit
This credit is intended to reimburse the employer for costs involved in implementing the plan, and for participant education.
To qualify, your business must have 100 or fewer employees who earned at least $5,000 in the prior year, and you cannot have sponsored a plan that covered substantially the same employees in the previous three years.
For employers with 50 or fewer employees, the credit covers 100% of your qualified costs. For employers that have between 51 and 100 employees, the credit covers 50% of your costs. Regardless of which percentage applies, the credit is capped at up to $5,000 per year, and you can claim it for the first three years the plan is in effect.
The dollar amount of the credit is calculated using the following formula:
$250 multiplied by the number of Non-Highly Compensated Employees (NHCEs) eligible to participate in the plan.
Therefore, if you have 20 or more eligible NHCEs, you will reach the maximum credit dollar amount of $5,000 (assuming you have at least that amount in qualified costs).
The Employer Contribution Credit
This credit provides a credit for matching or non-elective contributions the employer makes on behalf of their employees. The credit is up to $1,000 per employee earning less than $100,000. The credit is available over the first five years of the plan as follows:
Years 1 & 2: 100% of the eligible employer contribution.
Year 3: 75% of the eligible employer contribution.
Year 4: 50% of the eligible employer contribution.
Year 5: 25% of the eligible employer contribution.
Employers with 51 to 100 employees also qualify, but the credit percentage is reduced by 2 percentage points for every employee over 50.
The Automatic Enrollment Credit
An additional $500 per year tax credit is available for the first three years a new or existing plan includes an eligible automatic enrollment feature. Given that most new 401(k) and 403(b) plans starting after 2024 with 10 or more employees are required to include auto-enrollment, many new plan sponsors will automatically qualify for this credit, boosting the total potential startup credit.
New plans that are exempted from the requirement to include auto-enrollment include government, church, and SIMPLE 401(k) plans; plans sponsored by small businesses that normally employ 10 or fewer employees; and plans sponsored by businesses that have existed for less than three years.
In summary, an eligible small business can now receive up to $5,500 per year in administrative and auto-enrollment credits for three years, plus a multi-year credit for employer contributions. For many, the cost of establishing a retirement plan is now essentially federally subsidized.
Taking the Credit: IRS Form 8881
The primary form used to claim the Small Employer Pension Plan Startup Costs Credit, the Employer Contributions Credit, and the Auto-Enrollment Credit is IRS Form 8881: Credit for Small Employer Pension Plan Startup Costs, Contributions, Auto-Enrollment, and Military Spouse Participation.
Your tax preparer must complete this form and file it as an attachment to your federal business income tax return (such as Form 1120, 1120-S, or 1065).
Necessary Information and Documentation
To accurately complete Form 8881, your tax preparer will need the following information and documentation:
Eligible Employee Count: You must be able to verify that you had 100 or fewer employees who received at least $5,000 in compensation in the tax year preceding the first credit year.
Plan Start Date: The date the retirement plan became effective.
Qualified Startup Costs: Invoices or receipts detailing the ordinary and necessary expenses (setup fees, administrative costs, education expenses) incurred.
Non-Highly Compensated Employees (NHCEs): The number of employees eligible to participate in the plan who are not Highly Compensated Employees (HCEs). This is used in the calculation of the maximum startup costs credit.
Employer Contribution Amounts: Documentation of the qualifying employer contributions (matching or non-elective, excluding elective deferrals) made to the plan for the eligible employees (those making under the HCE compensation limit, currently $160,000 as indexed for the contributions credit).
Auto-Enrollment Confirmation: Verification that the plan includes an Eligible Automatic Contribution Arrangement (EACA), if claiming that credit.
Please note that you cannot claim a deduction for the same expenses for which you claim the tax credit. You must choose between the credit and the deduction for those startup costs.
As always, please feel free to contact our office with any questions regarding these important tax credits.