An employer’s guide to the small business retirement plan tax credit

How can adding a retirement plan earn your business a tax credit?

In simple terms, a tax credit reduces the amount of taxes you owe. It’s more rewarding than a tax deduction, which lowers your taxable income. The IRS allows eligible employers to claim a tax credit of up to $5,000, for three years, for the “ordinary and necessary costs of starting a SEP, SIMPLE IRA, or qualified plan.” Employers qualify to claim this credit if they meet the following criteria:

• Had 100 or fewer employees earning at least $5,000 in compensation in the preceding year;
• Had at least one plan participant who was a non-highly compensated employee (NHCE), meaning earning less than $100,000; or
• In the three years before the first year of eligibility for the credit, their employees were not substantially the same employees who received contributions or accrued benefits in another plan sponsored by the company, a member of a controlled group that includes the company, or a predecessor of either.

The small business retirement plan tax credit applies only to qualified startup costs for setting up a qualified retirement plan. This includes ordinary and necessary costs to set up and administer the plan and educate employees about the plan.

Now that we’ve covered the basics of why employers may want to take advantage of tax credits, let’s explore how these credits can help employers and their teams build savings for life after work.

Understanding retirement plans

Provided your company meets the above eligibility requirements, many different types of plans are eligible for the small business retirement plan tax credit. We break down a few of the most common retirement plans below.

Overview of SEP IRAs

A simplified employee pension (SEP) plan allows employers to set aside money in retirement accounts for both themselves and their employees. They’re available to any size business and can be easily set up using IRS Form 5305-SEP. These plans do not have the startup or operating costs of a conventional retirement plan and permit the contribution of up to 25 percent of each employee’s pay, making them attractive options for self-employed individuals and small companies.

With an SEP IRA, only the employer contributes and employees always have 100 percent ownership of their SEP IRA funds.

Overview of SIMPLE IRAs

A SIMPLE IRA stands for savings incentive match plan for employees. This type of IRA allows both employees and employers to contribute to traditional IRAs that are set up for employees’ benefit. It’s typically considered a good starting option for small employers that have not already set up a contribution plan.

SIMPLE IRAs are available to any business with 100 or fewer employees and are easily set up using IRS Form 5305-SIMPLE. Like SEP IRAs, employers have no filing requirement.

Overview of traditional 401(k)s

A traditional 401(k) is the most common employer-sponsored retirement plan for larger organizations. A 401(k) plan is a qualified profit-sharing plan that allows employees to elect to contribute a portion of their wages to their own retirement accounts. These contributions are pre-tax, meaning they lower the employee’s taxable income, and employers can choose to match or supplement in some way via employer contributions.

Employees tend to highly value 401(k) plans because of the employer match feature, which is essentially bonus compensation.

With a clear view of savings plans, let’s see how businesses that qualify for the small business retirement plan tax credit can get started.

Claiming tax credits: The role of Form 8881

Eligible businesses setting up qualified plans may claim the small business retirement plan tax credit using IRS Form 8881, Credit for Small Employer Pension Plan Startup Costs. The amount of the credit that you may apply for depends on your business.

For employers with 50 or fewer employees who received at least $5,000 in the previous year, the credit is worth 100 percent of eligible startup costs equal to the lesser of $250 multiplied by the number of NHCEs who are eligible to participate in the plan, or $5,000. All such employers are eligible for a minimum $500 credit.

For employers with 51-100 employees who received at least $5,000 in the previous year, the credit is worth 50 percent of eligible startup costs equal to the lesser of $250 multiplied by the number of NHCEs who are eligible to participate in the plan, or $5,000. Again, all are eligible for a minimum $500 credit.

Effectively claiming the credit entails a little tax planning work, which is just one area where a reliable payroll software can help.

Practical steps to set up retirement plans

Not every business is ready for a retirement plan. While the small business retirement plan tax credit is a nice incentive, it’s important to figure out if the timing makes sense for you and your employees. There are a few practical steps to consider.

Assessing business needs

Fundamentally, a retirement plan is a great perk to encourage employee retention and attract top talent. Employees are the lifeblood of any business, and happy employees are more productive and higher performing. That said, businesses have myriad expenses and operating costs to consider. While some retirement plans, like SEP and SIMPLE IRAs, are very low cost, a robust 401(k) plan may have more considerable costs. A retirement plan should improve your business’s value proposition, not put its working capital at risk.

Selecting a retirement plan provider

There are many retirement plan providers to choose from. Some of the most important factors to consider when searching for a provider are as follows:

• Pricing: Some plans have no fees, while others have exorbitant fees. Make sure you understand the pricing structure of any plan or partner, before making a choice.
• Customer service: Sometimes mistakes happen or questions come up. When it’s your employees’ money on the line, you want to make sure you’re working with a reliable, trustworthy partner.
• Simplicity: A great plan provider increases employee engagement and makes it easy for employees to understand their benefits and access their plans.
• Agility: Market conditions and compliance regulations change all the time, and your retirement plan partner should have the recordkeeping ability to adapt to changes and optimize your employees’ investments.

Preparing required documentation

Setting up a retirement plan is easiest, if you work directly with a partner who handles filing requirements with the IRS. That said, you can handle the administrative work yourself. The IRS provides a checklist of all the required documentation, but be forewarned: it’s extensive.