To ease the burden for small businesses, the SECURE 2.0 Act created a substantial new startup tax credit based on contributions the employer made on behalf of participants and expanded the existing startup tax credit on employer plan costs. Together, these tax credits may provide a significant benefit for small businesses that are starting a plan.
Currently, three separate tax credits exist for plan fees or contributions made by small enterprises. The following is an overview of each tax credit, which can help you ascertain your business's eligibility and the potential tax credit amount. Additionally, we have included a few examples to illustrate the range of these tax credits.
Tax credit #1: Startup tax credit
The credit was originally established through SECURE Act 1.0 and then augmented in SECURE 2.0, where a qualifying employer can claim up to 100% of its eligible expense for implementing and maintaining a 401(k) plan.
To qualify, a business must fulfill three criteria:
- Employ 100 or fewer workers who received a minimum of $5,000 in compensation from the employer in the previous year;
- Include at least one non-HCE* in your retirement plan; and
- In the three tax years prior to the first year, you're eligible for the credit, and your employees were not substantially the same individuals who obtained contributions or accrued benefits in another retirement plan sponsored by you, a member of a controlled group including you, or a predecessor of either.
* A non-Highly Compensated Employee (non-HCE) refers to an employee who is not classified as a Highly Compensated Employee (HCE). An HCE is an individual who:
- Held over 5% interest in the business at any point during the year or the previous year, irrespective of their earnings or compensation, or
- In the previous year, received over $135,000 (if the preceding year is 2022) or $150,000 (if the preceding year is 2023) from the business, and, if the employer opts, ranked in the top 20% of employees based on compensation.
Because of the one non-HCE requirement, owner-only businesses cannot benefit from the startup tax credit by adopting a solo 401(k) plan.
Additionally, due to the substantially same employee requirement, a company cannot leverage this tax credit by incorporating a 401(k) feature into an existing profit-sharing plan. A business also cannot terminate an existing 401(k) plan and establish a new one to obtain this tax credit.
Definition of qualified startup costs:
- Cost to establish or administer a qualifying retirement plan (e.g., 401(k)), or
- Cost associated with educating the employees about the plan (i.e., enrollment meeting)
An eligible employer with 50 or fewer employees may claim a tax credit for 100% of its qualified startup costs.
An eligible employer with 51 to 100 employees may only claim a tax credit for 50% of its qualified startup costs.
What is the maximum limit to the startup tax credit?
The maximum tax credit is $5,000 each year. The maximum tax credit is reduced for a business with less than 20 employees. The maximum for businesses with less than 20 employees cannot exceed $250 times the number of non-Highly Compensated Employees (non-HCEs) eligible for plan participation. An eligible employer can always claim a tax credit of at least $500 each year.
For example, a business with one owner and 15 non-HCEs may receive a tax credit of up to $3,750 (250 x 15).
A business with an owner, two managers, and 59 non-HCEs may receive a tax credit up to the $5,000 limit. Remember that a business with over 50 employees can only claim 50% of its qualified startup costs. Therefore, expenses incurred by this business to establish and administer the plan would have to exceed $10,000 a year to reach the $5,000 tax credit.
How long can an eligible employer claim the startup tax credit?
An eligible business is able to claim the tax credit for the first three years starting when the plan is effective.
How do you apply for a tax credit?
Go to IRS and look out for IRS Form 8881 (Credit for Small Employer Pension Plan Startup Costs) and file with your tax return to claim the startup tax credit. This form has not yet been amended to accommodate the SECURE 2.0 change allowing businesses with 50 or fewer employees to claim 100% of their qualified startup costs.
Tax credit #2: Employer Contribution Tax Credit
The government is highly committed to encouraging small businesses to offer retirement plans for their employees. If you believe that this is the extent of the available tax credits, you may be underestimating the government's determination. There is another tax credit incentive known as the employer contribution tax credit. To qualify for this credit, a business must satisfy the eligible employer criteria outlined in the startup tax credit section. The maximum limit is $1,000 per employee per year, provided that the employee's annual compensation does not exceed $100,000.
Tax Credit Calculation for Businesses with 50 or Fewer Employees:
A business with 50 or fewer employees may receive a tax credit for 100% of employer contributions in the first two years (including the startup year), 75% of employer contributions in the third year, 50% in the fourth year, and 25% in the fifth year. There is no tax credit available for employer contributions after the fifth year of the plans’ startup.
Here is how the numbers work, consider a business that established a 401(k) plan in 2023 with one owner (earning over $100,000) and 15 eligible employees (earning no more than $100,000). The plan permits salary deferrals and offers a 50% match on deferrals, capped at $1,000. Assuming all 15 eligible employees and the owner defer sufficiently to maximize the match, the business would obtain $52,500 in tax credits over a five-year period.
Tax Credit For Businesses with 51 to 100 Employees:
The tax credit for a business with 51 to 100 employees is based on a sliding scale. The percentage is reduced by 2 points for each employee over 50. To illustrate, the tax credit for a business with 80 employees would only be 40% (100% - (2% x 30)) of employer contributions for the first two years, 30% (75% x 40%) for the third year, 20% (50% x 40%) for the fourth year and 10% (25% x 40%) in the fifth year.
To illustrate, a business with 75 eligible employees (making no more than $100,000) starts a 401(k) plan in 2023. The employer of the plan provides a match of 100% of deferrals capped at deferrals up to 3% of compensation. Assume all employees defer enough to maximize the match contribution. As detailed below, the business would be receiving $105,000 in tax credits over five years. Employer contributions not eligible for the employer contributions tax credit may still be considered for tax deduction purposes.
Auto-Enrollment Tax Credit:
SECURE introduced an auto-enrollment tax credit, offering small businesses a $500 tax credit for adding an automatic enrollment feature to new or existing 401(k) plans. To be eligible, the feature must meet Eligible Automatic Contribution Arrangement (EACA) requirements, with QACA safe harbor 401(k) plans also qualifying. Eligible employers must have 100 or fewer employees earning at least $5,000 in the previous year.
Unlike the startup tax credit, the auto-enrollment tax credit applies to existing 401(k) and profit-sharing plans with a 401(k) feature. Eligible employers can add the feature and receive the tax credit for the first three years. Due to SECURE 2.0, starting in 2025, most 401(k) plans must have the auto-enrollment feature. Small businesses may want to adopt the feature now to minimize disruption in 2025 and benefit from the tax credit.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.