In an article published in April 2023, we told you about two tax credits added to the Internal Revenue Code (Code) by the SECURE Act 2.0. Both credits were effective for taxable years beginning after December 31, 2022, and were designed to encourage small employers to provide qualified retirement plans for their employees.
Since we published that article, we have often been asked how an employer gets the tax credits. This article will discuss how an employer actually gets the tax credits.
However, before we answer that question, there are a couple other questions that we need to answer.
WHAT IS A TAX CREDIT?
More taxpayers are familiar with tax deductions than with tax credits because deductions are more prevalent in the Code. Unlike a deduction, which reduces a taxpayer’s taxable income, a credit actually reduces the amount of taxes paid by the taxpayer. It is a dollar-for-dollar reduction of the amount of taxes owed by the taxpayer. For example, assume a taxpayer owes $1,000 in taxes but is entitled to a credit of $100. The credit reduces the taxpayer’s actual tax bill to $900. In that sense, a tax credit puts money in the taxpayer’s pocket.
A tax credit is a great benefit to a taxpayer. However, there is a caveat. Most tax credits are non-refundable. A non-refundable credit can only be used to reduce taxes actually owed. A taxpayer that does not owe taxes is unable to take advantage of a non-refundable tax credit. For our purposes, that is not a problem. Most small businesses have taxable income at the end of the year and will be able to take advantage of the tax credits added by the SECURE Act 2.0.
WHAT IS A SMALL EMPLOYER?
The Code contains a number of different definitions of the term “small employer” depending upon the context. However, for the two tax credits contained in the SECURE Act 2.0, the term generally means an employer with fewer than 100 employees, although there is a sub-category of “small employer” for employers with 50 or fewer employees.
HOW DOES THE START-UP CREDIT WORK?
One of the tax credits discussed in our previous article was the start-up credit. The start-up credit enables an employer to recover a portion of its expenses incurred in starting and administering a qualified retirement plan by reducing its overall tax bill. Covered costs include fees paid to financial advisors, third-party administrators and recordkeepers, as well as costs incurred in educating the employer’s workforce, and is available for the first three years of a plan’s existence.
How much is the credit? The answer depends upon whether the employer has 50 or fewer employees or between 51 and 100 employees. For the smaller employer, the credit is 100% of the costs incurred, limited as described herein. For employers with 51-100 employees, the credit is 50% of the costs. The amount of the credit is equal to the greater of $500 or the number of non-highly compensated employees multiplied by $250 with a cap of $5,000.
To illustrate, assume the ABC Company has 12 employees, ten of whom make less than $100,000 per year and are considered non-highly compensated. Also assume that the employer starts a qualified retirement plan and incurs costs of $6,000 per year for the first three plan years. The amount of the start-up credit is calculated as follows:
$6,000 x 100% = $6,000
The start-up costs eligible for the credit are $6,000. However, the credit is capped at the greater of $500 or $250 times the number of non-highly compensated employees.
$250 x 10 = $2,500
Since $2,500 is greater than $500, the employer in our example is entitled to a start-up credit of $2,500 for each of the first three plan years.
HOW DOES THE EMPLOYER MATCH CONTRIBUTION CREDIT WORK?
The second tax credit discussed in our previous article is the employer contribution credit. The purpose of this credit is to subsidize an employer’s contributions to a profit-sharing or 401(k) plan. This credit is available for a period of five years and is a decreasing percentage of the employer’s contribution per employee with a cap of $1,000 per employee. The credit percentage is 100% for years one and two, 75% for year three, 50% for year four and 25% for year five. Again, the calculation of the credit depends upon whether the employer has 50 or fewer employees or between 51 and 100 employees. Smaller employers are entitled to the full amount of the credit; while the credit percentage is reduced by 2% for each employee over 50 for employers with 51-100 employees.
To illustrate the employer contribution credit, let’s look again at the ABC Company. Let’s assume that the employer makes a matching contribution to the company’s 401(k) of 50% of the employee’s contribution up to $3,000. That means that, for each non-highly compensated employee, the ABC Company contributes $1,500 per employee.
$3,000 x 50% = $1,500
However, there is a cap of $1,000 per employee. The ABC Company’s employer contribution credit for each of the first five years of the plan is calculated as follows:
Year
1 100% x $1,000 x 10 = $10,000
2 100% x $1,000 x 10 = $10,000
3 75% x $1,000 x 10 = $7,500
4 50% x $1,000 x 10 = $5,000
5 25% x $1,000 x 10 = $2,500
HOW DOES THE EMPLOYER GET THE TAX CREDIT
In order to get the available tax credits, the employer needs to file Form 8881 with the Internal Revenue Service. Form 8881 is filed with the employer’s tax return. It is a one-page form that will take the employer through the calculations discussed above.
For information on how you can start a qualified retirement plan in 2024 and take advantage of this credit, contact the RMC Group at 239-298-8210 or rmc@rmcgp.com.
