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Small Business Retirement Guide: The $16,500 Tax Credit Small Businesses Can Claim

In the competitive world of small business, every advantage counts.

And now, thanks to the 2019 SECURE Act, there is a new, major benefit available to small businesses: a tax credit as high as $16,500, secured by offering a qualified retirement plan to employees. These include programs like a 401(k), a SIMPLE IRA, or a SEP, all of which may be easier to offer than you’d think.

In this article, we’ll review how the SECURE Act’s tax credits work, discuss how you can obtain them, and answer common questions you may have.

The SECURE Act: Tax Breaks for Small Businesses

Since 2001, businesses with 100 employees or less have had access to a retirement tax benefit: If you start offering a retirement plan to your employees, you can claim a tax credit equivalent to 50% of the total cost of establishing and communicating that plan, up to $500 per year. This credit has been a major boost to employers interested in recruiting and retaining top talent, opening the door for small businesses everywhere to help their employees save for retirement.

However, in 2020, this credit was significantly improved by the Setting Every Community Up for Retirement Enhancement (SECURE) Act. Among many other changes,​ the act increased the tax credit that eligible employers can use to claim a benefit of up to $5,000, for three years, for the “ordinary and necessary costs” of starting a qualified retirement plan and also provides an additional credit for certain automatic contribution arrangements.

For taxable years beginning prior to January 1, 2020, the credit was equal to 50% of the qualified start-up costs with a $500 maximum credit for the first plan year and $500 for the next two years.  And now, for plan years beginning after December 31, 2019, the dollar limit of the credit is increased to the greater of (1) $500, or (2) the lesser of $5,000, or $250 for each non-highly compensated employee (NHCE) who is eligible to participate in the plan.

What Are The Requirements For Claiming This Tax Credit?

The requirements for claiming these tax credits are fairly straightforward. You qualify if:

  • You had 100 or fewer employees who received at least $5,000 in compensation from you for the preceding year.
  • You had at least one plan participant who was a non-highly compensated employee (NHCE).
  • In the three tax years before you became eligible for the credit, your employees weren’t enrolled in another plan sponsored by you, a member of a controlled group that includes you, or a predecessor of either.

Are The SECURE Act Tax Credits A Flat $5,000 Benefit?

No, they are not. The credit is still capped at 50% of the startup costs, but is equal to $250 times the number of NHCEs eligible to participate in the plan, up to $5,000 annually. In practice, your startup credit is the greater of:

  • $500; or
  • the lesser of:
    • $250 multiplied by the number of NHCEs who are eligible to participate in the plan; or
    • $5,000

While that may sound complicated at first, there is a simple step-by-step process for calculating your potential tax credit.

How to Calculate Your Tax Credit

The tax credit is calculated in five steps:

  1. Determine how many NHCEs are eligible for the plan
  2. Multiply that number by $250
  3. The result from step #2 is the maximum tax credit for the year, subject to an overall cap of $5,000
  4. Determine your eligible plan expenses for the year—only those paid by the business, not those paid by or deducted from plan assets
  5. Multiply that number by 50%

The result from step #5 is your maximum permissible tax credit for the year. Other plan expenses can be taken as tax deductions, just not tax credits.

Example:  The ABC Company sponsors a new 401(k) plan on January 1, 2022, which covers the owner and five NHCEs, and costs $5,000 for the year.  In this case, the ABC Company’s start-up tax credit for 2022 would be $1,250: The greater of $500 or $250 times the number of NHCEs (5), but in no event more than 50% of the start-up costs.

Lastly, if you add an auto-enrollment feature to your plan, known as an eligible automatic enrollment arrangement (EACA), you can claim a tax credit of $500 per year for a three-year taxable period, beginning with the first taxable year after December 31, 2019. However, it’s important to know that this comes with a duty to notify employees of this feature, and that you must withhold wages from automatically enrolled participants at the plan’s default deferral rate.

What Counts As A “Qualified Startup Cost?”

Just as important as the number of NHCEs eligible to participate, you also need to understand what counts as a qualified startup cost for the plan. These are any ordinary and necessary expenses of an eligible employer which are incurred in connection with the establishment or administration of an eligible plan, or education of employees with respect to that plan. This includes:

  • Recordkeeping fees
  • Plan administration fees
  • Support services from your retirement vendor
  • Costs of educating your employees about the plan

Common Questions With Answers

You may have further questions about your business’s unique circumstances and your maximum deduction. Consulting with a financial advisor can give you the specific information you’re looking for, and some common questions include:

If my business already has a plan and starts a second one, can I claim the tax credits?

If the second plan is offered to substantially the same group of employees as the new retirement plan would be, then you would not be eligible for the startup credit. Also, if you would have a defined benefit plan and a defined contribution plan, then the plans are aggregated and treated as one plan.

If I had a solo 401(k) in prior years, then created a 401(k) plan for my company, would my business be eligible for the startup credit?

A solo 401(k) is a 401(k) plan covering one person, so the business’s 401(k) plan would not be a new plan. If you terminate the solo 401(k), then the new 401(k) plan could cover a substantially different group of employees and be eligible, but the sponsor would need to wait 12 months before starting the new plan.

Can I take the auto-enrollment credit if my business joins a multiple employer plan (MEP) or pooled employer plan (PEP)?

Yes, an employer participating in a MEP whose participants are subject to an EACA are eligible for the $500 automatic enrollment tax credit for taxable years beginning after December 31, 2019.  An automatic enrollment arrangement that does not meet the requirements of an EACA would not qualify for this credit.

Can an existing plan add auto-enrollment to get the new $500 credit?

Yes. The automatic enrollment credit is in addition to the start-up credit.  Please note that the credit is only available for taxable years starting in 2020 and would only apply for the first three years the feature is effective. An existing plan may add an EACA mid-year as long as it only applies to new participants. If it will apply to all participants, then the feature may only be added at the beginning of the next plan year.

Example:  ABC Company establishes a new 401(k) Plan covering 5 NHCEs with an EACA feature, effective January 1, 2022. Both the fiscal year and plan year are the same.  The start-up costs are $3,000.  ABC Company is eligible for the start-up credit totalling  $1,250 (the lesser of $1,250 ($250 x 5) or $1,500 (50% of the total start-up costs)).  The automatic enrollment credit for 2022 is $500.  ABC Company is entitled to a credit in 2022 totalling $1,750 ($1,250 start-up credit and $500 EACA credit) for 2022. The credit would be available in 2023 and 2024 based on the number of NHCEs eligible to defer to the plan with an EACA provision.

Conclusion: Should You Start a New 401(k) Plan?

The SECURE Act has made offering a retirement plan easier than ever before. As a small business owner, you have the opportunity to help close the savings gap, fight America’s growing retirement crisis, and lend a helping hand to your employees.

If you are interested in setting up a 401(k) account for your business to claim the SECURE Act tax credits, you can contact Vestwell to determine your benefit amount and start a no-hassle plan, all from the comfort of your home. Interested? Learn more here.