How do I utilize the 401(k) plan startup tax credit?

The 401(k) Plan Startup Tax Credit is a federal tax credit provided by the U.S. government to incentivize small businesses to establish and maintain 401(k) retirement plans for their employees. This tax credit is aimed at helping small businesses offset some of the costs associated with setting up and administering retirement plans, making it more affordable for them to offer these valuable benefits to their employees.

Eligibility Requirements

To qualify, your business should meet the following criteria:

• Have 100 or fewer employees who collectively earned at least $5,000 in compensation in the preceding year.
• Include at least one non-highly compensated employee (NHCE) as a plan participant. A NHCE is someone who owned 5% or less of the company at any point in the preceding year and received less than $135,000 of income in the preceding year (2022).
• Ensure that, in the three tax years before your eligibility for the credit, your employees weren’t substantially the same as those in another retirement plan sponsored by your business, a controlled group member, or a predecessor.

The Value of the Startup Tax Credit

For businesses with 50 or fewer employees, the available credit is 100% of eligible startup costs, up to the greater of:

$500; or

The lesser of:

• $250 multiplied by the number of eligible NHCEs or

• $5,000

For businesses with 51-100 employees, the available credit is 50% of eligible startup costs, up to the greater of:

$500; or

The lesser of:

• $250 multiplied by the number of eligible NHCEs or

• $5,000

The maximum tax credit is $5,000 each year. However, the maximum tax credit is reduced for a business with less than 20 employees since the maximum credit for businesses with less than 20 employees cannot exceed $250 times the number of eligible NHCEs. An eligible employer can always claim a tax credit of at least $500 each year.

Let’s look at some examples:

Example 1:

A business with 1 business owner, 1 manager, and 7 NHCEs would be eligible for a maximum startup tax credit of $1,750 ($250 x 7 NHCEs).

Example 2:

A business with 2 business owners, 4 managers, and 31 NHCEs would be eligible for a maximum startup tax credit of $5,000 (Although $250 x 31 NHCEs is $7,750, the credit is capped at $5,000).

Example 3:

A business with 3 business owners, 5 managers, and 85 NHCEs would be eligible for a maximum startup credit of $5,000. However, since they have more than 50 employees, they would only be able to claim 50% of its qualified startup costs, meaning they would need to exceed $10,000 of startup costs to claim the full $5,000 credit. If startup costs totaled $6,000, the maximum available credit would be $3,000.

The Length of the Credit

The startup tax credit is available for each of the first three years starting in the year the plan is effective.

Claiming the Credit on your Tax Return

Although the IRS has not yet amended the form with the updated SECURE 2.0 changes, you will still need to file IRS form 8881 to claim the available credit.

Employer Contribution Tax Credit

In addition to the 401k startup tax credit, also included in SECURE 2.0 was an additional tax credit made for employer contributions to 401(k) plans. Eligibility requirements are the same as the startup tax credit.

The Value of the Employer Contribution Tax Credit

With a maximum credit of $1,000 per NHCE, a business with 50 or fewer employees may receive a tax credit for 100% of employer contributions in the first two years, 75% of employer contributions in the third year, 50% in the fourth year, and 25% in the fifth year.

The tax credit for a business with 51 to 100 employees is based on a sliding scale. The maximum credit is still $1,000 per NHCE. However, the percentage is reduced by 2 points for each employee over 50. In other words, the tax credit for a business with 70 employees would only be 60% (100% – (2% x 20)) of employer contributions for the first two years, 45% (75% x 60%) for the third year, 30% (50% x 60%) for the fourth year and 15% (25% x 60%) in the fifth year.

Let’s go back to our examples:

Example 1:

A business with 1 business owner, 1 manager, and 7 NHCEs would be eligible for a maximum credit of $7,000 ($1,000 x 7 NHCEs) in years one and two, $5,250 ($1,000 x 0.75 x 7 NHCEs) in year three, $3,500 ($1,000 x 0.50 x 7 NHCEs) in year four, and $1,750 ($1,000 x 0.25 x 7 NHCEs) in year five for a total credit of $24,500 over those five years.

Example 2:

A business with 2 business owners, 4 managers, and 31 NHCEs would be eligible for a maximum credit of $31,000 ($1,000 x 31 NHCEs) in years one and two, $23,250 ($1,000 x 0.75 x 31 NHCEs) in year three, $15,500 ($1,000 x 0.50 x 31 NHCEs) in year four, and $7,750 ($1,000 x 0.25 x 31 NHCEs) in year five for a total credit of $108,500 over those five years.

Example 3:

A business with 3 business owners, 5 managers, and 85 NHCEs would be eligible for a maximum credit of $25,500 ($1,000 x 0.30 x 85 NHCEs) in years one and two, $19,125 ($1,000 x 0.225 x 85 NHCEs) in year three, $12,750 ($1,000 x 0.15 x 85 NHCEs) in year four, and $6,375 ($1,000 x 0.075 x 85 NHCEs) in year five for a total credit of $89,250 over those five years.

Auto Enrollment Tax Credit

In addition to the 401k startup tax credit, you also may want to consider the Auto-Enrollment Tax Credit, which aims to encourage employers to implement automatic enrollment features in their retirement plan. Expected benefits include promoting higher participation rates among employees, helping employees save for retirement by making enrollment the default option, and simplifying retirement plan enrollment by reducing the administrative burden on both employers and employees.

Unlike the startup tax credit and the employer contribution credit, the auto enrollment tax credit is available to any 401(k) plan that does not currently include that feature. As long as you amend the plan to include an auto-enrollment feature, you will be able to claim the flat $500 credit for the next 3 years.

Another result of the legislative change in SECURE 2.0, beginning in 2025, 401(k) plans must include the auto-enrollment feature. Although businesses starting 401(k) plans now do not need to have the auto-enrollment feature, they will be required to adopt the feature by 2025. With that in mind, small businesses implementing a 401(k) plan should consider adding the auto-enrollment feature now to minimize the potential disruption in 2025 as well as take advantage of this tax credit.

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