Small businesses often face significant financial barriers when launching retirement plans for their employees. Recognizing this challenge, the federal government established tax incentives designed to make retirement plans more accessible and affordable. The most significant of these incentives is the retirement plan startup costs tax credit, which was substantially enhanced by the SECURE Act of 2019 and further improved by SECURE 2.0 in late 2022. This credit allows eligible employers to substantially reduce the costs associated with starting and maintaining a retirement plan. For many small businesses, these tax credits can cover 100% of plan startup costs for the first three years, effectively making the establishment of a new 401(k) plan financially feasible. Beyond the immediate financial benefits, offering a retirement plan helps businesses attract and retain talent in an increasingly competitive job market while fostering employee financial wellness. Understanding the specific requirements and benefits of these tax credits is crucial for small business owners looking to maximize their financial advantages while providing valuable retirement benefits to their workforce.

Eligibility Requirements for the Startup Tax Credit

To qualify for the retirement plan startup tax credit, businesses must meet specific eligibility criteria established by the IRS. First, the employer must have had 100 or fewer employees who received at least $5,000 in compensation during the preceding year. This threshold ensures the credit targets small to medium-sized businesses that might otherwise struggle with the costs of establishing a retirement plan. Second, the plan must include at least one non-highly compensated employee (NHCE). As defined by the IRS, an NHCE is generally an employee who doesn't own more than 5% of the business and didn't receive compensation exceeding $155,000 in the preceding year (as of 2024). This requirement prevents solo business owners or owner-only plans from claiming the credit. Finally, the employer must not have maintained a retirement plan covering substantially the same employees during the three tax years preceding the first year of eligibility for the credit. This stipulation prevents businesses from terminating existing plans simply to claim the tax credit with a new plan. Additionally, businesses cannot claim this credit by merely adding a 401(k) feature to an existing profit-sharing plan, as it must be a genuinely new retirement plan offering.

Understanding the Startup Cost Credit Amount

The amount of the startup tax credit varies based on the number of employees in your business. For employers with 50 or fewer employees who received at least $5,000 in the previous year, SECURE 2.0 increased the credit to 100% of eligible startup costs, making it particularly attractive for small businesses. For businesses with 51-100 employees, the credit remains at 50% of eligible startup costs. The maximum credit amount is determined by a formula that considers the number of non-highly compensated employees eligible to participate in the plan. Specifically, the credit equals the greater of $500 or the lesser of: $250 multiplied by the number of NHCEs eligible for the plan, or $5,000. This means a business with 20 or more eligible NHCEs can receive the maximum annual credit of $5,000. The minimum credit is $500, ensuring that even the smallest businesses with only a few employees can benefit. Businesses can claim this credit for up to three consecutive tax years, potentially resulting in total savings of up to $15,000. Importantly, the credit cannot exceed the actual costs incurred, and businesses cannot both deduct the startup costs and claim the tax credit for the same expenses.

Qualified Startup Costs Explained

The IRS defines qualified startup costs as ordinary and necessary expenses paid or incurred by an employer in connection with establishing or administering an eligible employer plan or educating employees about retirement planning. These costs typically include expenses directly related to setting up and maintaining the 401(k) plan. Administrative fees paid to third-party administrators for plan setup, documentation, and ongoing administration qualify for the credit. Recordkeeping fees, essential for maintaining accurate participant records and ensuring compliance with regulatory requirements, are also eligible. Costs associated with educating employees about the plan, such as enrollment materials, financial education sessions, and retirement planning resources, fall under qualified expenses. It's important to note that only costs paid directly by the employer qualify for the credit. If plan expenses are paid from plan assets (deducted from participant accounts), they won't qualify for the tax credit. This distinction encourages employers to cover plan costs directly rather than passing them to employees. Investment-related expenses, such as fees embedded in mutual fund expense ratios, don't qualify for the credit. When establishing a 401(k) plan, business owners should carefully consider how plan expenses are structured to maximize their eligible tax credits.

The Employer Contribution Tax Credit

SECURE 2.0 introduced a significant new tax credit specifically for employer contributions to retirement plans. This credit is separate from and in addition to the startup cost credit, providing further financial incentives for small businesses. The employer contribution tax credit is available for contributions made to employees earning $100,000 or less annually (adjusted for inflation). For businesses with 50 or fewer employees, the credit equals 100% of qualified employer contributions in the first and second years, 75% in the third year, 50% in the fourth year, and 25% in the fifth year. For businesses with 51-100 employees, the credit percentage is reduced by 2% for each employee exceeding 50. The maximum credit per employee is capped at $1,000 annually, determined on an employee-by-employee basis. For example, if an employer contributes $800 to one employee's account and $1,500 to another's, the credit would be $800 for the first employee and $1,000 for the second (capped at the maximum). This credit significantly reduces the cost of making matching or non-elective contributions to employee accounts, encouraging employers to contribute more generously to their employees' retirement savings while reducing their own tax burden.

Auto-Enrollment Tax Credit Benefits

In addition to the startup and employer contribution credits, small businesses can receive a separate tax credit for implementing automatic enrollment in their retirement plans. This credit provides $500 per year for three consecutive years, resulting in potential savings of $1,500. The auto-enrollment feature automatically enrolls eligible employees in the plan unless they explicitly opt out, typically starting with a default contribution rate of 3% of salary. This approach increases employee participation rates significantly compared to traditional opt-in approaches. To qualify for this credit, a business must have 100 or fewer employees who received at least $5,000 in compensation during the preceding year. Unlike the startup credit, there's no requirement that the plan include at least one non-highly compensated employee. The auto-enrollment feature must meet Eligible Automatic Contribution Arrangement (EACA) requirements as defined by the IRS. Importantly, this credit is available not only for new plans but also for existing plans that add an auto-enrollment feature. This makes it particularly valuable for established businesses looking to increase employee participation. SECURE 2.0 mandates that 401(k) plans established after December 29, 2022, must include automatic enrollment by 2025, making this credit even more relevant for businesses starting new plans.

Military Spouse Tax Credit Overview

SECURE 2.0 introduced a specialized tax credit designed to help military spouses participate in workplace retirement plans, addressing the unique challenges they face due to frequent relocations. Small employers with 1-100 employees that hire military spouses and include them in their defined contribution plan, SEP, or SIMPLE IRA plan may be eligible for this credit. To qualify, the military spouse cannot be a highly compensated employee, must be eligible to participate in the plan within two months of hiring, should be eligible for matching or nonelective employer contributions as if they were employed for two years, and must be 100% vested in all contributions. The credit amount consists of $200 for employing the military spouse, plus 100% of the contributions made to their retirement account, up to $300. This creates a maximum possible credit of $500 per military spouse. Employers can claim this credit for up to three years for each military spouse participating in the plan. This credit acknowledges the employment challenges faced by military spouses and incentivizes employers to provide immediate retirement benefits despite potentially shorter employment periods, helping these individuals build retirement security despite frequent job changes associated with military service.

How to Claim Your 401(k) Tax Credits

To claim these valuable tax credits, businesses must file IRS Form 8881, "Credit for Small Employer Pension Plan Startup Costs," with their annual tax return. This form has specific sections for claiming the startup cost credit, auto-enrollment credit, and military spouse credit. The employer contribution credit is also claimed on this form. Before filing, gather documentation of all qualified expenses, including invoices and receipts for plan administration costs, educational materials, and records of employer contributions made to employee accounts. Keep detailed records showing which employees received contributions and their compensation levels to substantiate claims for the employer contribution credit. It's advisable to work with a knowledgeable tax professional or retirement plan advisor who understands these credits, as the calculations can be complex, particularly for businesses with 51-100 employees where phase-out rules apply. The credits are nonrefundable, meaning they can reduce your tax liability to zero but cannot result in a refund. However, any unused credit may be carried back or forward to other tax years according to the general business credit carryforward provisions. Small business owners should note that Form 8881 has been updated to reflect the enhanced credits under SECURE 2.0, so ensure you're using the current version when filing.

Real-World Cost Savings Examples

To illustrate the substantial impact these tax credits can have, consider a small construction company with seven employees, including the owner earning $120,000 and six employees earning between $40,000 and $80,000 annually. Without tax credits, starting a 401(k) plan might cost approximately $2,000 in setup fees and annual administration costs of $1,500, plus employer matching contributions of about $10,500 annually (assuming a 3% match for all employees). With the startup cost credit covering 100% of administrative expenses for three years (up to $5,000 annually) and the employer contribution credit covering 100% of matching contributions (up to $1,000 per eligible employee) for the first two years, the company's effective cost is drastically reduced. In the first year, instead of spending $13,000 on their 401(k) plan, the company would receive tax credits totaling $9,500, reducing their net cost to just $3,500—primarily the cost of the owner's match which exceeds the $100,000 compensation threshold. Similarly, a technology startup with 25 employees (3 owners/executives and 22 staff earning under $100,000) implementing a plan with auto-enrollment would receive up to $5,000 in startup cost credits, $500 for auto-enrollment, and up to $22,000 in employer contribution credits annually for the first two years, substantially offsetting the real cost of their plan.

Strategic Planning for Maximum Tax Benefits

To maximize benefits from these tax credits, businesses should strategically time the establishment of their retirement plan. Since startup costs from the year before plan implementation can qualify for the credit, consider beginning preparations in one tax year with the plan becoming effective in the following year, effectively extending the credit period. When selecting a plan provider, prioritize transparent fee structures that allow costs to be paid directly by the business rather than from plan assets, as only employer-paid expenses qualify for the credit. For businesses approaching 50 employees, it may be advantageous to establish a plan before crossing that threshold to capture the 100% credit rate rather than the reduced 50% rate for larger businesses. Consider implementing a safe harbor plan design with auto-enrollment from inception, which satisfies certain nondiscrimination testing requirements while qualifying for both the startup and auto-enrollment credits. Structure employer contributions to maximize the contribution credit by ensuring contributions to employees earning under $100,000 are at least $1,000 each to capture the full credit amount. Finally, consider consulting with retirement plan specialists and tax professionals who understand these credits in detail and can help design a plan that optimizes tax benefits while meeting your business's retirement plan objectives.