Form 8881 Instructions: Complete in a Few Easy Steps! ✅


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I’ve got some good news for you if you were thinking about opening up a retirement plan. You may be eligible for a substantial tax credit on Form 8881 to offset your plan costs.

Plans covered under this credit would be any qualified plans that cover eligible employees. Qualified plans include cash balance plans, defined benefit plans, safe harbor 401(k)s, and even SEPs and SIMPLE plans.

But before you get too excited there are are some critical rules and requirements. In this post, will walk through and determine whether or not you qualify for the tax credits.

Assuming you do, we will walk-through filing Form 8881 and all the required instructions. The form really isn’t that challenging, but there are a few tips and tricks you can learn along the way.

Easy Navigation: Form 8881

A little about the SECURE Act

The good news is that the credit was recently enhanced. On December 20, 2019, the Setting Every Community Up for Retirement Enhancement Act (also called the “SECURE” Act) was signed into law.

The Act made some large changes to retirement plans. But most specifically, it greatly increased tax credits for small business owners who set up a new cash balance plan, defined benefit plan or 401(k).

In addition, it provides an additional credit for enrollment features added to any 401(k). For the majority of business owners, these changes took place effective January 1, 2020. 

Just in case you don’t know, a tax credit is much more valuable than a tax deduction. A tax deduction will allow you to deduct the administration fees so you save at your marginal tax bracket. So if your tax bracket is 30% you will save $.30 for every dollar in plan costs.

But a tax credit is much more valuable. It allows you to reduce your tax liability dollar for dollar. So if you qualify for a $2,000 tax credit and you paid $2,000 in fees, your net cost is zero. Not such a bad deal.

In fact, you’re able to claim this cost for the first three years of the plan including any start-up costs. That’s why this deduction has become so much more valuable.

How does the tax credit work?

So let’s get started. You can claim a federal tax credit for necessary and ordinary costs of starting up a plan. He will claim the credit with form 8881 which is called credit for small employer pension plan start up costs.

This form is not filed separately from your tax return. You’ll file it as a separate schedule to your business tax before return.

So if you file a partnership it will be included on Form 1065, C-Corps will include it on Form 1120, and S-Corps will include on Form 1120-S. If you are a sole proprietor, you’ll just file it as a separate schedule to your Form 1040. Your accountant should have some insight into how the form is attached. But if there any questions this post should come in handy.

Am I eligible?

So let’s first take a look at eligible employers. You can take the credit on Form 8881 if the following conditions are met:

  • You have 100 or fewer employees who had over $5,000 in W2 compensation for the prior year;
  • You had at least one eligible participant who was not deemed a highly compensated employee; and
  • In the three years prior to the first year you claim the credit, your employees weren’t essentially the same employees who received retirement contributions under another plan you sponsored.

It also restricts plans covered under a controlled group. In this post we won’t spend a lot of time discussed controlled groups. But let’s just say that if you (or your wife) have another business, you might want to discuss controlled groups with your accountant or CPA.

What is the difference between a cash balance plan and a defined benefit plan?

The eligible cause are any fees you incurred to set up and administer the plan and also cost to educate your employees about the plan requirements.

The bad news is that most solo plans because they don’t have any qualifying employees. The business owner is considered a highly compensated employee. These employees are specifically excluded from the credit calculation on Form 8881.

How is the tax credit calculated?

You can cane the credit for each of the first three years that you adopted the plan. In addition you can select to claim the credit in the tax year before the plan becomes effective if you choose. This helps out a lot for Safe Harbor 401(k) plans that are set up in the year before they are effective.

So let’s now go through how the credit is calculated. It can get a little complex, so try to stick with me. The credit is calculated as the greater of:

(1) $500 or (2) the lesser of (a) $250 multiplied by the number of non-Highly Compensated Employees (non-HCEs) who are eligible for the plan or (b) $5,000.

For practical purposes, the credit will be calculated for most businesses as $250 per eligible employee (excluding the business owner). Then it will be capped at $5,000.

Taxes written on hanging tags

You can take the credit for up to three years. So if your plan costs are $2,000 per year, you can claim a $6,000 cumulative tax credit.

Form 8881 Instructions

The credit is actually part of the general business credit requirements and you can also carry it forward or back to other years if you can’t use it in the current year of adoption. But don’t forget. If you are claiming the credit you’re not allowed to deduct the start up cost on your tax return. You can’t double-dip.

Quick reference FAQs

Final thoughts on Form 8881

Determining if you are eligible for tax credits on your new retirement plan may be an after-thought. But don’t let it be. You may find that the credit will cover your administrative costs for the first three years. So don’t forget to discuss with your CPA and make sure to file Form 8881.

Have a question? Schedule a FREE call with a CPA…

Paul Sundin, CPA has written articles on retirement planning for Inc., Kiplinger and others. He focuses on cash balance plans and other defined benefit plans. Schedule a FREE 30 minute call: Schedule Appointment!

Paul Sundin

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