Quick Summary
Federal tax credits can offset much of the cost of starting a new retirement plan for a small employer. Businesses with 50 or fewer employees can claim a credit of 100% of eligible startup costs, up to set limits, for each of the first three years, and businesses with 51 to 100 employees can claim 50%. A separate credit of up to $1,000 per eligible employee can offset employer contributions for up to five years, and adding automatic enrollment can bring an additional $500 credit per year for three years. Eligibility depends on employee counts, prior plans, and controlled group rules, so confirm the details with your tax professional.
Cost is one of the most common reasons small business owners give for not offering a retirement plan. Setup fees, administration, and employer contributions can look like a lot for a company with a handful of employees.
Federal tax credits change that math. The SECURE Act of 2019 and SECURE 2.0 in 2022 expanded the credits available to small employers that start a plan, and for many businesses the credits cover a large share of early costs. A tax credit reduces the tax you owe dollar for dollar, which makes it more valuable than a deduction of the same amount.
Who qualifies
According to the IRS, an employer can generally claim the startup credit if:
- It had 100 or fewer employees who received at least $5,000 in compensation in the preceding year;
- The plan has at least one participant who is a non-highly compensated employee; and
- In the three tax years before the first credit year, substantially the same employees were not receiving contributions or benefits under another plan maintained by the employer, a member of its controlled group, or a predecessor.
That last condition matters for business owners with more than one company. Controlled group rules can treat related businesses as one employer, which affects both employee counts and prior-plan history.
Credit 1: Plan startup costs
For employers with 50 or fewer employees, the credit equals 100% of eligible startup costs. For employers with 51 to 100 employees, it equals 50%. In either case, the annual credit is limited to the greater of:
- $500, or
- The lesser of $250 for each eligible non-highly compensated employee, or $5,000.
Eligible costs include the ordinary and necessary costs to set up and administer the plan and to educate employees about it. The credit is available for each of the first three years of the plan.
Credit 2: Employer contributions
SECURE 2.0 added a credit for employer contributions to a defined contribution plan, SEP, or SIMPLE IRA. For employers with 50 or fewer employees, the credit for each eligible employee is:
- First and second years: 100% of employer contributions, up to $1,000 per employee
- Third year: 75%
- Fourth year: 50%
- Fifth year: 25%
The credit does not apply to contributions for employees earning more than $100,000, a threshold that is adjusted for inflation. Employees' own salary deferrals do not count, only the employer's money. For employers with 51 to 100 employees, the percentage is reduced by 2 percentage points for each employee above 50.
Credit 3: Automatic enrollment
An employer that adds an eligible automatic enrollment feature can claim an additional $500 credit per year for three years. This credit is available to new plans and to existing plans that add automatic enrollment.
There is also a credit of up to $500 per year, for up to three years, for eligible small employers whose plans include a non-highly compensated military spouse who meets certain participation and vesting conditions.
An illustration
Consider a hypothetical company with 20 employees, 15 of whom are eligible non-highly compensated employees. It pays $3,000 a year in plan setup and administration costs, makes $1,500 in employer contributions for each of 10 employees earning under the wage threshold, and includes automatic enrollment.
- Startup cost credit: The limit is the lesser of $250 × 15 ($3,750) or $5,000, so $3,750. The company's $3,000 in costs is under that limit, so the credit is $3,000.
- Employer contribution credit: Each of the 10 employees counts up to $1,000, so the first-year credit is $10,000.
- Auto-enrollment credit: $500.
In this illustration, the first-year credits total $13,500. Actual results depend on your company's facts, and this example is for illustration only.
How to claim and coordinate
The credits are claimed on IRS Form 8881. A few coordination points:
- You cannot both deduct startup costs and claim a credit for the same expenses.
- The credits are part of the general business credit, so if the credit exceeds the tax you owe, carryover rules may apply.
- For pass-through businesses, such as S corporations and partnerships, the credit generally flows through to the owners.
- Because the credits offset income tax, most tax-exempt organizations cannot currently benefit from them.
Your CPA should confirm eligibility and calculate the credits for your return.
A Connecticut note
Many Connecticut employers that do not sponsor a retirement plan must facilitate the state's MyCTSavings program. Facilitating the state program does not generate these federal plan credits, because the credits apply to employer-sponsored plans such as 401(k), SEP, and SIMPLE IRA plans. For some businesses, the credits make sponsoring their own plan more affordable than they expected.
Questions to bring to your CPA
- How many employees received at least $5,000 in compensation last year?
- Do we, or does a related business, have any retirement plan now or within the past three years?
- Which of our startup and administration costs qualify?
- How many employees fall under the wage threshold for the contribution credit?
- Should we elect to treat the prior tax year as the first credit year?
Thinking about starting a plan? Brian Williams, CPFA®, of Northshire Consulting LLC | Registered Investment Advisory Firm helps business owners compare plan options and work through startup decisions with their tax advisors. Call 203-401-6062, email bwilliams@northshireconsulting.com, or visit northshireconsulting.com to schedule a plan review.
Frequently asked questions
Can an existing plan claim these credits?
The startup cost credit and employer contribution credit are aimed at new plans and generally apply in a plan's first years. An existing plan that adds automatic enrollment may qualify for the $500 auto-enrollment credit.
Do SEP and SIMPLE IRA plans qualify?
According to the IRS, the startup cost credit and the employer contribution credit can apply to SEP and SIMPLE IRA plans as well as qualified plans such as a 401(k).
Does the owner's own contribution count toward the contribution credit?
Generally, no. The contribution credit does not apply to employees earning above the wage threshold, which typically includes owners. The startup cost limit is also based on the number of eligible non-highly compensated employees.
This material is for educational purposes only and is not individualized investment, tax, or legal advice. Advisory services are offered through Northshire Consulting LLC | Registered Investment Advisory Firm.