The IRS has given small business owners many reasons to set up a retirement plan for their employees. The SECURE 2.0 amended an existing tax credit provision for administrative expenses for startup plans by doubling the credit for companies with 50 or fewer employees.
Added to this enhancement is a new tax credit for plan contributions for newly established plans for small companies. The combined tax credits can make many new plans almost free for the first two years. After year two, the company can receive partial credits for contributions for another two years.
This article discusses the tax credit for administrative fees. When a “small” employer incurs administrative expenses for establishing and operating a plan, there are tax credits for those payments for the first three years of the plan.
This article discusses these two new provisions and shows you how to maximize the credits. Let’s dive in!
Small Business Startup Credit
Thanks to the Secure Act 2.0, the IRS changed the startup tax credit by increasing the credit from 50% to 100% for businesses that have up to 50 employees. The credit percentage is 100% for the first and second years. Then it is reduced to 75% in year three, 50% in year four, and 25% in the fifth year. No credit is available after year five. This is effective for tax years beginning subsequent to December 31, 2022.
This credit is for small employers. A small employer is defined as one that has up to 100 qualified employees. For companies that have 1 to 50 eligible employees, the IRS tax credit is 100% of the setup and administrative fees. It is capped at $5,000.
For companies with 51 to 100 participating employees, the tax credit percentage is lowered to 50%. All employees who earned at least $5,000 of compensation from the company in the prior year are considered.
To be eligible for the administrative credit, the company must have at least one non-highly compensated eligible participant. Finally, a business is not eligible if it substantially covers the same employees in a qualified retirement plan, SIMPLE IRA, or SEP IRA in the three prior tax years.
The $5,000 limit is not as straightforward as it may appear. Specifically, the limit is calculated as follows:
- The business receives a $250 credit for each eligible employee who is not considered highly compensated. As a result, for up to 20 employees, the tax credit would be below $5,000. But companies with 20 employees or more would be capped at $5,000.
- The minimum is $500, and the maximum is $5,000
The credit only applies to covered expenses (“qualified startup costs”) the employer pays. Qualified startup costs are defined as:
- any ordinary and necessary expenses of an eligible company that are paid (or incurred) in association with:
- (i) the setup or administration of an eligible company plan, or (ii) the retirement-related education of employees concerning the plan.
Considering the above definition, the eligible costs include payment for plan administration, recordkeeping, and employee education services.
Contribution Tax Credits
The Act created a new credit for company contributions to startup plans. The additional tax credit generally will be a percentage of the employer’s contribution for employees. This extra credit is only available for companies with 50 or fewer employees and is phased out for employers between 51 and 100 qualifying employees. The tax credits are based on plan contributions other than contributions to defined benefit plans.
For companies with 50 or less employees in the prior year, the credit is 100% of the plan contributions made for eligible employees for the first two years but caps at $1,000 per employee. The method used for counting the number of employees is the same as for the startup cost credit. It includes any employee who made at least $5,000 from the company.
However, for plan contribution purposes, it counts eligible employees in the year for which the contributions are made. This is in contrast to the startup credit, where the count is for the year prior to the year the credit is claimed. Of course, the tax credit is only applicable for contributions made for eligible employees and allocated to their plan accounts.
In addition, the credit is only for contributions made for qualifying employees who make less than $100,000 in the tax year that the tax credit is claimed. The IRS will adjust the amount in future years for cost-of-living increases. Wages are defined the same as for Social Security (FICA).
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Any credits are reduced after year two. The credit reduces 75% for the third year, 50% for the fourth year, and 25% for the fifth year. There are no contribution tax credits after that.
For example, if an eligible company structures a plan to contribute $1,000 for each of its 20 participants who make less than $100,000, the company will contribute $20,000 and receive a tax credit of $20,000 for the first two years. This effectively offsets the cost of the contributions for the first years and partially offsetting them for the three years after.
If the company has 51 to 100 employees, the contribution tax credit reduces pro-ratably at 2% for employees over 50. As with the tax credit for startup costs, the contribution credit is not allowed if the company has covered substantially the same employees in a qualified plan, SIMPLE IRA, or SEP IRA in the three preceding taxable years.
However, unlike the credit for startup costs, this limitation on the contribution tax credit will apply only to the first-year credit amount. Said differently, the company will be entitled to the 2nd, 3rd, 4th, and 5th-year credits for contributions. In addition to the qualified tax credits for administrative fees and contribution costs, there is another $500 tax credit for setting up a plan with automatic enrollment.
In conclusion, SECURE 2.0 amended the existing tax credit for administrative costs by doubling the value for companies with 50 or fewer employees. The intent is to encourage the establishment of new plans by small companies. That is because the most significant need for retirement plan coverage is with small employers.
This enhancement and the new credit for contributions for newly established plans will hopefully accomplish this goal. The combined tax credits will often make a new plan almost free for the first three years. After that, a company will receive partial credits for contributions for another two years.