By: Scott M. Cloud, MBA, CPC
Employers that establish a brand new employee retirement savings plan are eligible for a tax credit for each of the plan’s first three years. The tax credit amount is capped at $5,000 for each of the plan’s first three years (i.e., up to $15,000 total), but is limited by 1) the amount of the plan’s service fees that are paid by the employer (versus being paid from employee accounts), and 2) the number of “non-highly compensated employees” (NHCEs; those with gross annual wages below $135,000) who are eligible for the plan. The formula that is used to calculate the tax credit amount is provided below under “Startup Plan Tax Credit Calculation”.
Employers who are Eligible for the Tax Credit
An employer qualifies for the tax credit if:
- It had 100 or fewer employees who received at least $5,000 in gross wages in the preceding year.
- It had at least one plan participant who was a non-highly compensated employee (NHCE) in the current year.
- In the three tax years before the first year that the employer is eligible for the credit, its employees weren’t substantially the same employees who were eligible in another plan sponsored by the same employer or by a related employer.
What Plan Costs are Eligible for the Tax Credit
An employer may claim the tax credit for ordinary and necessary costs to:
- Set up and administer the plan, and
- Educate employees about the plan
That is, virtually all costs that are associated with setting up and administering/maintaining the plan and that are paid by the employer are eligible plan costs in calculating the tax credit amount.
Eligible Plan Types
The tax credit applies for each of the first three years in which an employer maintains any one of the following:
- Simplified Employee Pension Plan (SEP)
- SIMPLE IRA
- 401(k) Plan
- Profit-Sharing Plan/Money Purchase Plan
- Defined Benefit/Cash Balance Plan
For example, if an employer maintains a SEP for two years and then establishes a 401(k) plan in Year 3, only those three years would be eligible for the tax credit. The three-year period for which the employer is eligible for the tax credit would not start over upon the adoption of the 401(k) plan.
Startup Plan Tax Credit Calculation
The tax credit applies in each of the new retirement savings plan’s first three years, and is calculated separately for each of the first three years as follows:
A. Number of Eligible NHCEs * x $250 =
B. Lesser of: A or $5,000 =
C. Greater of: B or $500 =
D. 50% of the plan setup/administration costs that were paid by the employer that year =
E. Lesser of C or D = the Startup Plan Tax Credit amount for the year
* A non-highly compensated employee (NHCE) is any employee who had gross wages of less than $135,000 in the prior year (not including family members of the business’ owner(s)).
Summary
To encourage employers to establish an employee retirement savings plan by reducing the costs that are associated with maintaining the plan, the IRS offers a tax credit for each of a new retirement savings plan’s first three years. The tax credit amount is capped at $5,000 for each of the plan’s first three years, but is limited by 1) the amount of the plan’s service fees that are paid by the employer, and 2) the number of eligible “non-highly compensated employees”. For most employers, the tax credit amount is equal to half of the plan costs that are paid by the employer in each of the plan’s first three years. If you have questions about eligibility for the tax credit and/or about calculating/estimating the tax credit amount, please contact TRPC Sales at 888-673-5440, option 4.