Retirement Tax Credit for Small Businesses
In previous eras employers did not opt for 401(k) plans, or other retirement plans, due to the complexities and costs associated with running a small business retirement plan. However, it has changed with the new SECURE Act coming into effect from January 1, 2020. The new amendment allows for retirement solutions that are easy and profitable for both employees and the employer. Notably, there are several employer-friendly changes in the new retirement plan, namely, a significant increase in 401k tax credits for those who start a new plan or add an automatic enrollment feature to the existing plan.
The new Act has benefits that span over more than a year, although you need to be eligible for the same (discussed later in the article). A maximum of $5000 tax credit is now allowed by the IRS which is increased by $4500 – an increase of 900%!
This enormous increase makes understanding the new tax credits and benefits even more important. So, let’s get started.
What are the new SECURE Act retirement plan costs tax credits?
According to the new SECURE Act tax credits, an eligible small business can claim a tax credit for adopting a SEP, SIMPLE IRA or qualified plan (like a 401(k) plan.) The new additions in the Further consolidated Appropriations Act, 2020, include
- Increase in retirement plan startup cost credit limit
- All new credit for Automatic enrollment in savings for retirement
Startup Cost Credit or Qualified Startup Cost
After the SECURE Act came into effect, an eligible small business can now claim a tax credit of 50% of your eligible startup costs, up to the greater of:
- $500; or
- The lesser of:
- $250 multiplied by the number of NHCEs who are eligible to participate in the plan, or
The qualified startup cost tax credit is available for a maximum of three years, and you can’t both deduct the startup costs and claim the credit for the same expenses. You aren’t required to claim the allowable credit.
A small business can add the automatic enrollment feature to the existing or new plan, and become eligible to earn an additional $500 tax credit each year each year for the first three years when the feature is effective.
Consequently, when someone becomes an employee, he gets automatically enrolled in the small business retirement plan. However, an employee can opt-out of the plan if they so choose.
To take advantage of this, however, the automatic enrollment feature must meet the Eligible Automatic Contribution Arrangement (EACA) requirements.
“Qualified Startup Costs” Explained
According to the Internal Revenue Service (IRS), a qualified startup cost means any ordinary or necessary expenditure by an eligible employer either incurred or paid in relation to:
- Establishing an eligible employer plan or
- The retirement-related education of employees connected to such a plan
Note: The plan should have a minimum of one employee eligible for participation. All eligible employer plans undertaken by the same employer are counted as one eligible employer plan. Also, the employers do not stand liable for any missed payments by the employees. The IRS grants them a fiduciary safe harbor.
First Credit Year
The first credit year starts from the date the plan turns effective. However, an employer can choose to have the previous year as the first credit year and henceforth claim the credit. For instance, a small employer whose plan becomes effective on January 1, 2021, may choose 2020, as the first credit year and claim credit for 2020 fiscal year. The 401k tax credit is $500 or 50% of your startup cost.
You may claim the credit for ordinary and necessary costs to:
- Set up and administer the plan, and
- Educate your employees about the plan.
Note: These are different than the “business startup costs”
How to Know if Your Small Business is Eligible
Not all employers are eligible for small business retirement plan tax credit. To gain eligibility, a business should fulfill the following requirements:
- The business had 100 or fewer employees who received $5,000 or more in compensation from the business for the preceding year;
- The business had at least one plan participant who was a non-highly compensated employee (NHCE); and
- In the three tax years before the first year you’re eligible for the credit, your employees weren’t substantially the same employees who received contributions or accrued benefits in another plan sponsored by you, a member of a controlled group that includes you, or a predecessor of either. This means you likely can’t switch from another plan type to the new plan just to take the credit.
You may ask, what is the definition of a non-highly compensated employee? According to the Internal Revenue Service (IRS), a highly compensated employee is a person who:
- Received compensation of more than $120,000 for the preceding year
- The chosen employee was in the top 20% of the employees in ranking for compensation. or
- Owns at least 5% interest in the company either in the same year or the preceding year.
If the criteria above is met, then the employer can claim credit for the startup expenses. Note that the small employer definition varies within the tax code. For instance, In the Affordable Care Act, the upper limit is 50 full-time employees. This implies that some large businesses under ACA or certain other provisions will still qualify for this credit.
Claiming the Credit
Now, to claim tax credit for the costs of starting a retirement plan, all eligible small business owners should use Form 8881. The form has two parts:
- Part I: a small employer can claim credit for pension plan startup costs.
- Part II: a small employer can claim credit for auto-enrollment in retirement savings.
With Part I, as allowed under section 45E, an eligible small employer can claim qualified startup cost credit to administer or establish an employer plan.
Under Part II of Form 8881, as allowed under section 45T, a small employer can claim credit for having an eligible automatic contribution in an employer plan.
However, small business employers having a partnership or S-corporation business structure do not need to file this form. If their sole source of income is from S-corporations or partnerships, then they can typically claim the credit on Form 3800 directly.
Moreover, Form 8881 should be filed with your income tax return, and remember, you cannot claim the tax credit and also deduct the startup cost for the same expenses. A small employer can claim credit for each of the first three years of the retirement plan, and as discussed earlier, you are free to claim credit in the tax year prior to the year when the plan turns effective.
The claimed credit comes under general business credit. You may choose to take it forward or backwards to other tax years, if you are unable to use it in the same year. But you are not permitted to take it back to a tax year that begins before January 1, 2002.
Further, be sure that the plan you start(ed) will qualify, as not all plans are created equal under this law. Some of the most common plans offered by the employers under Form 8881include:
- SEP IRAs and SIMPLE IRAs
- 401(k) Plans, including profit-sharing plans
- Money purchase pension plans
- Defined benefit pension plans where the plan guarantees a specific benefit when they retire
Before you claim the credit, be sure to check with your CPA that your company qualifies based on the IRS’s rules, and to determine if the credit or deducting the expenses would be better for you, as in some cases the credit is not as beneficial as deducting all of the costs.
How the SECURE Act Affects Overall Cost of a New 401(k) Plan?
Let’s take an example to understand small business tax credit for 401k startup costs.
Jack, a small business employer, starts a 401(k) plan for his business. He has nine employees and wants them to save for their retirement and at the same time, manage his company’s finances. The plan he chooses a monthly base costs of $39 and an additional $8 per month for each participating employee.
Here is the showdown for the example savings explained step by step:
|Guidelines 401 (k)
|Employer Base Fee
|Plan Participant Fee
|Total Cost Per Year
|Reduce by Credit
Jack can take away $500 credit for the first year of the tax credit plan. In the second and third year, if Jack does not increase the number of his employees, the total cost would incur $1332 and will be compensated by $500 tax credit.
The tax credit is available for the first three fiscal years of starting the plan. This implies that a small business employer can receive $1500 in tax credits. This can compensate for his startup costs, including setup, administration, and employee education.
As the small business owners are also employees, you can leverage 401 (k) plans for yourself, with benefits in tax for contributions, tax deferred growth, bankruptcy and creditor protection and higher limits than IRAs. The combination of the credit is
With Setting Every Community Up for Retirement Enhancement (SECURE) Act, A small business owner can start a retirement plan for the employees and thus reduce the overall tax liability. Also, it can lower the price of starting a new 401 (k) plan.
Similar to tax deduction that provides tax liability on the taxable income, tax credit can take away some of the tax burden. Small business owners face this burden in the initial years of operating and growing their business. The good news is that all eligible employers can claim small business retirement plan tax credit and receive this relaxation!
- https://www.guideline.com/blog/how-you-can-save-twice-on-a-new-401-k/ visual