Taxes: Tax Credits for Pension Plan Start-up Costs | IMA (2024)

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 introduced a number of changes to various retirement tax code provisions. Section 104 of the Act encourages small business owners to adopt a retirement plan by increasing the tax credit for small employer pension plan start-up costs. And a new tax credit was added under SECURE Act §105 to defray start-up costs for 401(k) and Savings Incentive Match Plan for Employees (SIMPLE) IRA plans that include automatic enrollment. These and other changes will make it easier for small business owners to help support their employees’ efforts to plan and save for retirement.

A CREDIT FOR START-UP COSTS

A qualified small business owner who doesn’t currently have a qualified retirement plan is encouraged to start one and thereby claim a tax credit for the plan’s qualified start-up costs in each of the first three years of the plan (IRC §45E). IRC §45E(c)(2) clarifies the requirement for new qualified employer plans: An eligible employer can’t have sponsored another qualified plan for substantially the same employees during the three tax years prior to claiming the tax credit.

Beginning with plans in the year 2020, the tax credit for start-up costs of a new plan is a two-part comparison. Begin by taking the lesser amount of $5,000 or $250 multiplied by the number of employees who aren’t considered highly compensated employees (HCEs). Then take the greater of that amount or 50% of the start-up cost (but no less than $500). That makes for a possible total tax credit of $5,000 per year (or $15,000 for the three tax years) so long as the eligible employer had 20 or more non-HCEs for each of the three years ($250 × 20 = $5,000).

An HCE is one who passes an ownership or a compensation test (IRC §414(q)). Under the ownership test, an HCE is a 5% owner at any time during the current plan year or the preceding 12 months. Under the compensation test, an HCE is an em­ployee who earns more than $125,000 for 2019 and $130,000 for 2020 (IRS Notice 2019-59). Alternatively, employees in the top 20% of employees ranked by compensation are considered HCEs.

To be eligible for the credit, employers can’t have more than 100 em­ployees who received at least $5,000 of compensation from that employer for the preceding year (IRC §408(p)(2)(C)(i)). Also, at least one participant in the plan must be a non-HCE.

Qualified pension plans are defined by IRC §4972(d) to include IRC §401(a) qualified plans such as 401(k)s, 403(a) annuity plans, Simplified Employee Pension plans, or SIMPLE IRA plans. These plans offer both employers and employees a tax-favored way of saving for retirement because an employer can deduct the contributions made to the plan and earnings on the contributions are tax deferred until distributed to the employees.

AUTOMATIC ENROLLMENT

The SECURE Act also provides a new $500-per-year tax credit for employers who have or start a 401(k) plan or SIMPLE IRA plan that adds automatic enrollment to their new plans or existing plans (IRC §45T). Even if an employer adopts the automatic contribution arrangements, the em­ployee still has the option to elect not to participate or use a different contribution percentage to the plan.

This automatic enrollment not only encourages employees to more actively participate in the plan, but it also helps an employer ensure its plans have fuller employee participation. Therefore, an eligible employer can receive tax credits of up to $1,500 for including automatic enrollment (automatic enrollment credit of $500 per year for three years) in addition to the $15,000 credit for starting a plan, resulting in total tax credits up to $16,500.

QUALIFIED START-UP COSTS

Qualified start-up costs are any ordinary and necessary expenses paid or incurred in connection with establishing or administrating the plan or retirement-related education of employees for the plan (IRC §45E(d)(1)). There doesn’t appear to be more specific guidance by the IRS as to what constitutes qualified start-up costs to help employers understand them better; however, the U.S. Department of Labor for Em­ployee Benefits Security Administration published Understanding Retirement Plan Fees and Expenses in December 2011 (bit.ly/3bMqEpJ) that provides more government guidance, even if it’s an older publication.

The administration fees for the plan generally include the costs of setting up the plan and its day-to-day operations, such as recordkeeping transactions as well as accounting, legal, and trustee services. In addition, other services may be provided to the employees, including telephone and website systems for customer service, online transactions, and access to plan information and valuation; educational material, seminars and webcasts; and possibly investment advice. If these expenses are paid by the employer and not by the employee, they’re qualified start-up costs.

CLAIMING THE CREDIT

The start-up tax credit is currently claimed on IRS Form 8881 for tax year 2019. Although the credit may be claimed for each of the first three years of the plan, an employer may choose to start claiming the credit in the tax year prior to the plan becoming effective. For example, an eligible employer whose plan is effective on January 1, 2021, may elect to treat 2020 as the first credit year and therefore start claiming the credit on its 2020 tax return for qualified start-up costs incurred in 2020.

An employer may elect to deduct these costs as a business expense and reduce the taxable income instead of claiming a tax credit. IRC §45E(e)(2) points out that the employer isn’t able to deduct the portion of the qualified start-up costs paid or incurred for the taxable year that equals the credit. In other words, a taxpayer can’t double-dip for both the tax credit and tax deduction for the same amount of costs—it must be one or the other. In addition, any pension start-up costs deduction must be reduced by the credit amount.

Small business owners wear many hats, and it’s no surprise that retirement plans aren’t high on their agenda. Since such a significant amount of the U.S. workforce is employed by small businesses, this increased tax benefit will hopefully encourage small business employers to set up retirement plans for their employees.

© 2020 A.P. Curatola