Are you self-employed and considering establishing a solo 401(k) plan? You might be missing out on a favored tax credit from the SECURE Act 2.0: the Automatic Enrollment Tax Credit.
Tax credits can be confusing and many miss out on the tax savings. In fact, many CPAs are unaware of the credit. But if you understand the rules, you save $1,500 on your taxes!
In this post I will discuss the automatic enrollment tax credit. Will tell you how it works and also show you the form that needs to be filled out in order to receive it. Let’s jump in.
What is the Secure Act 2.0?
The SECURE Act 2.0 is a comprehensive legislative package aimed at expanding retirement savings, improving retirement plan access, and increasing retirement security for Americans. Building on the original SECURE Act of 2019, this updated legislation introduces numerous provisions to address the evolving challenges of retirement planning.
Key features include increasing the age for required minimum distributions (RMDs) to 73 starting in 2023 and to 75 by 2033, enhancing catch-up contributions for older workers, and providing automatic enrollment incentives for new workplace retirement plans. These changes aim to encourage greater participation in retirement savings programs and help individuals save more effectively for their retirement years.
One of the standout features of SECURE Act 2.0 is the emphasis on making retirement savings accessible to a broader range of workers. For example, it includes provisions that allow part-time employees to participate in 401(k) plans after working at least 500 hours annually for two consecutive years.
Additionally, it creates new tax credits for small businesses to offset the costs of establishing retirement plans, with additional credits available for adding automatic enrollment features. These measures collectively aim to address systemic barriers to saving and adapt retirement planning to the financial realities of today’s workforce.
Two Different Tax Credits for Retirement Plans
Many business owners and tax professionals alike, confused these two tax credits. That’s because the assumption is that these credits are not for owner only businesses.
There are two separate tax credits related to 401(k) plans. The credits often need clarification. Here they are:
- 401(k) Startup Cost Credit
- Auto-Contribution Credit
Here’s a comparison of these two credits:
The 401(k) Auto-Enrollment Tax Credit: A Solo business owner’s guide
Here are some of the critical details of the Auto-Contribution Credit:
- It can be claimed by solo 401(k) plan owners
- You do NOT need to have any employees other than the owner
- The plan document must contain an auto-enrollment feature
- You may claim up to $500 annually for three years
- It is a provision of the SECURE Act and is separate from the Startup Cost Credit
Many CPAs are familiar with the 401(k) Startup Cost Credit, which requires non-highly compensated employees. They mistakenly apply this rule to all 401(k)- related credits. However, the Auto-Contribution Credit has no such restriction.
| Feature | Start Up Credit | Auto-Enrollment Credit |
|---|---|---|
| Eligibility | Requires Non-HCE employees | No requirement |
| Maximum Amount | $5,000 per year for 3 years | $500 per year for 3 years |
| Applies to | Companies with 100 or fewer employees | Any eligible business including solos |
| Key Requirement | Must cover at least 1 non-HCE | Must include auto-enrollment feature |
Auto-Enrollment Credit Is a Tax Credit, Not a Tax Deduction
Understanding the difference between a tax credit and a tax deduction is essential for maximizing your tax benefits. A tax deduction reduces your taxable income, decreasing the income subject to tax. However, the actual savings from a tax deduction depend on your tax bracket. For instance, if you are in the 30% tax bracket, a $500 deduction will save you only $150, which is 30% of $500.
Unlike a tax deduction, a tax credit will reduce your tax liability dollar-for-dollar. For instance, a $500 tax credit lowers your tax bill by $500, regardless of your income or tax bracket, making it significantly more advantageous than a deduction.
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Example: claiming a tax credit vs. tax reduction
- Tax deduction: A $500 tax deduction at a 30% tax rate lowers your taxable income to $44,500, resulting in $150 in income tax savings.
- Tax credit: A $500 tax credit directly reduces your tax liability by $500, resulting in substantially more tax savings.
The Auto-Contribution Credit is available to solo 401(k) owners with an auto-enrollment feature. This credit allows you to claim up to $500 per year for three years, saving you a total of $1,500 over time. Unlike a tax deduction, a tax credit like the Auto-Contribution Credit offers more significant savings, making it a valuable benefit for solopreneurs.
Auto-Enrollment Credit Example
Assume that Mr. Moore is a self-employed attorney earning $400,000 a year. He established a solo 401(k) with auto-enrollment in 2024. Here’s a summary of the tax credits by year:
- Tax year 2024: $500 credit
- Tax year 2025: $500 credit
- Tax year 2026: $500 credit
Total savings over the three years: $1,500
Are You Allowed to Claim Both Tax Credits?
Suppose you’re a self-employed business owner sponsoring a solo 401(k). In that case, you might wonder whether you can simultaneously claim the 401(k) Startup Cost Credit and the Auto-Contribution Credit. Unfortunately, the answer is no.
The primary reason for this is the eligibility criteria for the 401(k) Startup Cost Credit. This credit is intended for businesses that have non-owner employees. To qualify for the credit, the company must include at least one non-owner employee actively participating in the plan. However, a complication arises when considering the requirements for a solo 401(k), which is only available to business owners without full-time W-2 employees who are non-owners or non-spouses.
Simply put, if you’re self-employed and eligible for a solo 401(k), you disqualify yourself from the 401(k) Startup Cost Credit because you cannot claim the required non-owner employees.
Is a Cash Balance or Defined Benefit Plan Right For You?
You may still be eligible for the Auto-Contribution Credit, even if you do not have any non-owner employees, as solopreneurs can also claim it. However, your solo 401(k) plan must include an auto-enrollment feature to qualify for this credit. If you meet these criteria, you can receive a credit of up to $500 annually for three years, totaling $1,500.
How to Maximize the Tax Credits
Maximizing your tax credits is essential for managing a self-employed business. For solopreneurs, the Auto-Contribution Credit can be a valuable way to offset the costs of setting up and maintaining a solo 401(k). This credit can lead to total savings of up to $1,500 over three years, making it worthwhile to ensure that your retirement plan includes the auto-enrollment feature.
It’s essential to understand when a tax credit is not available. Many business owners wrongly assume they qualify for the 401(k) Startup Cost Credit when establishing a solo 401(k). However, they often discover later that they need to meet the requirement of having non-owner employees. This misunderstanding can result in frustration and missed opportunities to benefit from the appropriate tax credits.
You can effectively reduce your tax liability by understanding the differences between the 401(k) Startup Cost Credit and the Auto-Contribution Credit. It’s essential to stay informed about IRS tax regulations and seek professional guidance to maximize your benefits under current laws.
How to Claim Your Credit
IRS Form 8881, Credit for Small Employer Pension Plan Startup Costs and Auto-Enrollment Option, provides a tax credit to small employers who establish qualified retirement plans and incorporate automatic enrollment features. The form is primarily used to claim the startup cost credit, which covers 50% of eligible expenses for setting up and maintaining the plan, up to a maximum of $5,000 annually for three years.
However, an additional credit of $500 per year is available for employers who add an automatic enrollment feature to their retirement plan. Auto-enrollment simplifies participation for employees, as it enrolls them into the plan by default, encouraging higher savings rates and reducing inertia in employee decision-making.
To claim the auto-enrollment tax credit, employers must include automatic enrollment provisions when creating or modifying their retirement plans. This credit is available for up to three years, providing a total potential benefit of $1,500 in addition to the startup credit. To claim these credits, employers should complete Form 8881, ensuring all relevant sections for startup costs and automatic enrollment are filled out accurately.
The form must then be attached to the employer’s income tax return for the year in which the costs were incurred or the auto-enrollment feature was implemented. By taking advantage of these tax credits, small employers can reduce the financial burden of offering retirement benefits and foster better savings habits among their employees.
To claim the Auto-Contribution Credit, you must do the following:
- Ensure that your solo 401(k) plan includes an auto-enrollment feature.
- Complete Form 8881 to claim the credit on your income tax return; and
- Consult with a CPA familiar with this credit
Final Thoughts
Don’t let confusion lead to financial loss. When setting up a solo 401(k), ensure you include the auto-enrollment feature. Additionally, remember to claim your Auto-Contribution Credit. This small detail can significantly impact your tax bill.
Keep in mind that while many CPAs are still adapting to the newer provisions, you can stay ahead by understanding the details of these credits. Always consult a financial advisor or 401(k) specialist who is current on the latest tax laws to ensure you maximize your benefits.
