Achieving financial security doesn’t end with getting a job. Even as a new employee completes onboarding documents, they’re considering how much to contribute to a retirement plan. But this option isn’t always realistic — especially for employees of new or small businesses. Luckily, the Retirement Plans Startup Costs tax credit helps organizations with less than 100 employees offset the costs associated with the first three years of introducing a retirement plan.
Today, retirement plans may seem like a given for most benefit packages. For good reason, too. These long-term investments can:
- boost retention
- attract committed talent
- reduce employees’ taxable income
In fact, the existence of a retirement plan can be enough to indicate that a company doesn’t just intend to last, but anticipates doing so for multiple workforce generations.
Think the retirement plans tax credit could help your small business? Here’s what you need to know about what the tax credit is, how to qualify and how a single HR software helps make applying easier.
What is the Retirement Plans Startup Costs tax credit?
The Retirement Plans Startup Costs tax credit is an income tax credit. Businesses with 100 or fewer workers — including charitable or religious organizations — can apply for the credit to alleviate the costs of starting a retirement plan for employees for the plan’s first three years. Retirement plans that may qualify for the tax credit include:
- 401(k) plans
- 403(b) plans (aka tax-sheltered annuity plans)
- Simplified Employee Pension plans
- Savings Incentive Match Plan for Employees (SIMPLE) IRAs
- SIMPLE 401(k) plans
- and more
The Setting Every Community Up for Retirement Enhancement (SECURE) Act established retirement plan tax credits in 2019. Revised again in late 2022, the SECURE Act was designed to expand retirement options and increase plan savings. While some of the law’s provisions focus on individuals, the retirement plan tax credits help employers help their people.
How does the tax credit work?
The retirement plans tax credit works by reducing an employer’s income tax by the amount it costs to set up a qualifying retirement plan for employees. In total, the credit offers up to $5,000 annually for up to three years.
Remember, tax credits work differently than deductions in that they reduce your total income tax liability. According to CNBC, this often makes tax credits more valuable than deductions as they lower a company’s total tax bill, rather than simply reducing what’s taxable.
Who is eligible for the tax credit?
In addition to employing 100 or fewer workers, a business may qualify for the retirement plans tax credit if:
- its employees were paid at least $5,000 in the previous year
- in the three years before applying, the company had substantially different employees who received contributions or benefits through a different plan
- one or more plan participants don’t qualify as a “highly compensated employee”
According to the IRS, a highly compensated employee is someone who owns more than 5% interest in the business or earned at least $125,000 in the previous year. This could also be a worker who the employer ranked in the top 20% of earners at the company.
Since what qualifies as “highly compensated” can change each year, it’s important to stay on top of the latest updates. Use this table as a reference for some of the most recent years:
| Income Threshold for Highly Compensated Employees | |
| Preceding year | Earnings |
| 2019 | $125,000 |
| 2020 | $130,000 |
| 2021 | $130,000 |
| 2022 | $135,000 |
| 2023 | $150,000 |
What expenses qualify for the tax credit?
The retirement plans tax credit may be claimed for expenses that are ordinary and necessary to:
- set up a new retirement plan
- administer the plan to employees
- inform workers about their new option
Additionally, employers may not claim the credit and deduct the same expenses that helped them qualify. Always consult a licensed tax professional to verify which option would be best for your situation.
How do businesses apply for the tax credit?
Companies must use IRS Form 8881 to apply for the retirement plans tax credit. The filing deadline is no later than three years from the eligible plan’s start date.
The Form 8881 is split into two parts:
- Part 1: This portion covers qualified startup costs for establishing and administering an eligible plan.
- Part 2: This section is used if a business provides an eligible, automatic contribution arrangement for the retirement plan.
Consult the IRS’s Form 8881 instructions for more details about completing this process.
Some businesses rely on an internal specialist or outsource their payroll tax credit application forms. For particularly small operations, this may be the responsibility of the chief financial officer.
Others may use a certified public accountant (CPA) firm to prepare a tax return but would still need to provide their CPA with the completed Form 8881.
How is the tax credit calculated?
The retirement plans tax credit is 50% of eligible startup costs. If this amount is over $500, the credit is worth the lesser of:
- $5,000
- $250 times the number of workers who aren’t highly compensated employees
Remember, the threshold for highly compensated employees can change each year. For example, if you’re applying the tax credit to 2020, an employee who currently makes more than $130,000 could still help you qualify if their wage was lower in 2020.
Does the tax credit result in a tax refund?
The retirement plans tax credit can yield a tax refund in certain cases. But this depends on whether the tax amount a company owes is less than the value of the tax credit.
Of course, if the tax amount is less than the credit, it could increase an organization’s potential refund. On the other hand, if the tax amount is still higher than the credit, it just reduces the total amount of taxes owed.
Companies should always consult a licensed professional before applying for the retirement startup tax credit.
Explore Paycom to learn how it simplifies payroll, compliance and other HR responsibilities.
DISCLAIMER: The information provided herein does not constitute the provision of legal advice, tax advice, accounting services or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional legal, tax, accounting or other professional advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation and for your particular state(s) of operation.
