3 New Startup 401(k) Tax Credits
When Congress passed the Secure Act 2.0 in December 2022, they introduced new tax credits and enhanced old tax credits for startup 401(k) plans. There are now 3 different tax credits that are available for startup 401(k) plans that were put into place to help companies to subsidize the cost of sponsoring a retirement plan and also to subsidize employer contributions made to the employees to enhance the company’s overall benefits package. Here are the 3 startup 401(k) credits that are now available to employers:
Startup Tax Credit (Plan Cost Credit)
Employer Contribution Tax Credit
Automatic Enrollment Tax Credit
Startup Tax Credit
To incentivize companies to adopt an employer-sponsored retirement plan for their employees, Secure Act 2.0 enhanced the startup tax credits available to employers starting in 2023. This tax credit was put into place to help businesses offset the cost of establishing and maintaining a retirement plan for their employees for the first 3 years of the plan’s existence. Under the new Secure 2.0 credit, certain businesses will be eligible to receive a tax credit for up to 100% of the annual plan costs.
A company must meet the following requirement to be eligible to capture this startup tax credit:
The company may have no more than 100 employees who received compensation of $5,000 or more in the PRECEDING year; and
The company did not offer a retirement plan covering substantially the same employees during the PREVIOUS 3 YEARS.
The plan covers at least one non-HCE (non-Highly Compensated Employee or NHCE)
To identify if you have a NHCE, you have to look at LAST YEAR’s compensation and both this year’s and last year’s ownership percentage. For the 2023 plan year, a NHCE is any employee that:
Does NOT own more than 5% of the company; and
Had less than $135,000 in compensation in 2022. For the compensation test, you look back at the previous year’s compensation to determine who is a HCE or NHCE in the current plan year. For 2023, you look at 2022 compensation. The IRS typically increases the compensation threshold each year for inflation.
A note here about “attribution rules”. The IRS is aware that small business owners have the ability to maneuver around ownership and compensation thresholds, so there are special attribution rules that are put into place to limit the “creativity” of small business owners. For example, ownership is shared or “attributed” between spouses, which means if you own 100% of the business, your spouse that works for the business, even though they are not an owner and only earn $30,000 in W2, they are considered a HCE because they are attributed your 100% ownership in the business.
Besides just attribution rules, employer-sponsored retirement plans also has control group rules, affiliated service group rules, and other fun rules that further limit creativity. Especially for individuals that are owners of multiple businesses, these special 401(k) rules can create obstacles when attempting to qualify for these tax credits. Bottom line, before blindly putting a retirement plan in place to qualify for these tax credits, make sure you talk to a professional within the 401(k) industry that understands all of these rules.
401(k) Startup Tax Credit Amount
Let’s assume your business qualifies for the 401(k) startup tax credit, what is the amount of the tax credit? Here are the details:
For companies with 50 employees or less: The credit covers 100% of the company’s plan costs up to an annual limit of the GREATER of $500 or $250 multiplied by the number of plan-eligible NHCE, up to a maximum credit of $5,000.
For companies with 51 to 100 employees: The credit covers 50% of the company’s plan costs up to an annual limit of the GREATER of $500 or $250 multiplied by the number of plan-eligible NHCE, up to a maximum credit of $5,000.
This is a federal tax credit that is available to eligible employers for the first 3 years that the new plan is in existence. If you have enough NHCE’s, you could technically qualify for $5,000 each year for the first 3 years that the retirement plan is in place.
A note on the definition of “plan-eligible NHCEs”. These are NHCEs that are also eligible to participate in your plan in the current plan year. NHCEs that are not eligible to participate because they have yet to meet the eligibility requirement, do not count toward the max credit calculation.
What Type of Plan Costs Qualify For The Credit?
Qualified costs include costs paid by the employer to:
Setup the Plan
Administer the Plan (TPA Fees)
Recordkeeping Fees
Investment Advisory Fees
Employee Education Fees
To be eligible for the credit, the costs must be paid by the employer directly to the service provider. Fees charged against the plan assets or included in the mutual fund expense ratios do not qualify for the credit. Since historically many startup plans use 401(k) platforms that utilize higher expense ratio mutual funds to help subsidize some of the out-of-pocket cost to the employer, these higher tax credits may change the platform approach for start-up plans because the employer and the employee may both be better off by utilizing a platform with low expense ratio mutual funds, and the employer pays the TPA, recordkeeping, and investment advisor fees directly in order to qualify for the credit.
Note: It’s not uncommon for the owners of the company to have larger balances in the plan compared to the employees, so they also benefit by not having the plan fee paid out of plan assets.
Startup Tax Credit Example
A company has 20 employees, 2 HCEs and 18 NHCEs, and all 20 employees are currently eligible to participate in the new 401(k) plan that the company just started in 2023. During 2023, the company paid $3,000 in total plan fees directly to the TPA firm, investment advisor, and recordkeeper of the plan. Here is the credit calculation:
18 Eligible NHCEs x $250 = $4,500
Total 401(k) Startup Credit for 2023 = $3,000
Even though this company would have been eligible for a $4,500 tax credit, the credit cannot exceed the total fees paid by the employer to the 401(k) service providers, and the total plan fees in this example were $3,000.
No Carry Forward
If the company incurs plan costs over and above the credit amount, the new tax law does not allow plan costs that exceed the maximum credit to be carried forward into future tax years.
Solo(k) Plans Are Not Eligible for Startup Tax Credit
Due to the owner-only nature of a Solo(K) plan, there would not be any NHCEs in a Solo(K) plan, so they would not be eligible for the startup tax credit.
401(k) Employer Contribution Tax Credit
This is a new tax credit starting in 2023 that will provide companies with a tax credit for all or a portion of the employer contribution that is made to the 401(k) plan for employees earning no more than $100,000 in compensation.
The eligible requirement for this employer contribution credit is similar to that of the startup tax credit with one difference:
The company may have no more than 100 employees who received compensation of $5,000 or more in the PRECEDING year; and
The company did not offer a retirement plan covering substantially the same employees during the PREVIOUS 5 YEARS.
The plan makes an employer contribution for at least one employee whose annual compensation is not above $100,000.
Employer Contribution Tax Credit Calculation
The maximum credit is assessed on a per-employee basis and for each employee is the LESSER of:
Actual employer contribution amount; or
$1,000 for each employee making $100,000 or less in FICA wages
$1,000 Per Employee Limit
The $1,000 limit is applied to each INDIVIDUAL employee’s employer contribution. It is NOT a blindfolded calculation of $1,000 multiped by each of your employees under $100,000 in comp regardless of the amount of their actual employer contribution.
For example, Company RTE has two employees making under $100,000 per year, Sue and Rick. Sue receives an employer contribution of $3,000 and Rick received an employer contribution of $400. The max employer contribution credit would be $1,400, $400 for Rick’s employer contribution, and $1,000 for Sue’s contribution since she would be subject to the $1,000 per employee cap.
S-Corp Owners
As mentioned above, the credit only applies to employees with less than $100,000 in annual compensation but what about S-corp owners? The only compensation that is taken into account for S-corp owners for purposes of retirement plan contributions is their W2 income. So what happens when an S-corp owner has W2 income of $80K but takes a $500,000 dividend from the S-corp? Good news for S-corp owners, the $100,000 comp threshold only looks at the plan compensation which for S-corp owners is just their W2 income, so an employer contribution for an S-corp would be eligible for this credit as long as their W2 is below $100,000 but they would still be subject to the $1,000 per employee cap.
5-Year Decreasing Scale
Unlike the startup tax credit that stays the same for the first 3 years of the plan’s existence, the Employer Contribution Tax Credit decreases after year 2 but lasts for 5 years instead of just 3 years. Similar to the startup tax credit, there is a deviation in the calculation depending on whether the company has more or less than 50 employees.
For companies that have 50 or fewer employees, the employer contribution tax credit phase-down schedule is as follows:
Year 1: 100%
Year 2: 100%
Year 3: 75%
Year 4: 50%
Year 5: 25%
50 or Less Employee Example
Company XYZ starts a new 401(k) plan for their employees in 2023 and offers a safe harbor employer matching contribution. The company has 20 eligible employees, 18 of the 20 are making less than $100,000 for the year in compensation, all 18 employees contribute to the plan and each employee is eligible for a $1,250 employer matching contribution.
Since the tax credit is capped at $1,000 per employee, that credit would be calculated as follows:
$1,000 x 18 Employees = $18,000
The total employer contribution for these 18 employees would be $1,250 x 18 = $22,250 but the company would be eligible to receive a tax credit in year 1 for $18,000 of the $22,250 that was contributed to the plan on behalf of these 18 employees in Year 1.
Note: If an employee only receives a $600 employer match, the tax credit for that employee is only $600. The $1,000 per employee cap only applies to employees that receive an employer contribution in excess of $1,000.
51 to 100 Employees
For companies with 51 – 100 employees, the employer contribution credit calculation is slightly more complex. Same 5 years phase-down schedule as the 1 – 50 employee companies but the amount of the credit is reduced by 2% for EACH employee over 50 employees. To determine the amount of the discount you multiply 2% by the number of employees that the company has over 50, and then subtract that amount from the full credit percentage that is available for that plan year.
For example, a new startup 401K has 80 employees, and they are in Year 1 of the 5-year discount schedule, the tax credit would be calculated as follows:
100% - (2% x 30 EEs) = 40%
So instead of receiving a 100% tax credit for the eligible employer contributions for the employees making under $100,000 in compensation, this company would only receive a 40% tax credit for those employer contributions.
Calculation Crossroads
There is a second step in this employer contribution tax credit calculation for companies with 51 – 100 that has the 401(K) industry at a crossroads and will most likely require guidance from the IRS on how to properly calculate the tax credit for these companies when applying the $1,000 per employee cap.
I’m seeing very reputable TPA firms (third-party administrators) run the second half of this calculation differently based on their interpretation of WHEN to apply the $1,000 per employee cap and it creates different results in the amount of tax credit awarded.
Calculation 1: Some firms are applying the $1,000 per employee cap to the employer contributions BEFORE the discounted tax credit percentage is applied.
Calculation 2: Other firms apply the $1,000 per employee cap AFTER the discounted tax credit is applied to each employee’s employer contribution for purposes of assessing the $1,000 cap per employee.
I’ll show you why this matters in a simple example just using 2 employees:
Sue and Peter both make under $100,000 in compensation and work for Company ABC which has 80 employees. Company ABC just implemented a 401(K) plan this year with an employer matching contribution, both Sue and Peter contribute to the plan, Sue is entitled to a $1,300 matching contribution and Peter is entitled to a $900 matching contribution.
Since the company has over 80 employees, the company is only entitled to a 40% credit for the eligible employer contribution:
100% - (2% x 30 EEs) = 40%
Calculation 1: If Company ABC applies the $1,000 per employee limit BEFORE applying the 40% credit, Sue’s contribution would be capped at $1,000 and Peter’s contribution would be $900, resulting in a total employer contribution of $1,900. To determine the credit amount:
$1,900 x 40% = $760
Calculation 2: If Company ABC applies the $1,000 per employee limit AFTER applying the 40% credit:
Sue: $1,300 x 40% = $520
Peter: $900 x 40% = $360
Total Credit = $880
Calculation 2 naturally produces a high tax credit because the credit amount is being applied against Sue’s total employer contribution of $1,300 which is then bringing her contribution in the calculation below the $1,000 per employee limit.
Which calculation is right? At this point, I have no idea. We will have to wait and see if we get guidance from the IRS.
Capturing Both Tax Credits In The Same Year
Companies are allowed to claim both the 401(K) Startup Tax Credit and the Employer Contribution Tax Credit in the same plan year. For example, you could have a company that establishes a new 401(k) plan in 2023, that qualifies for a $4,000 credit to cover plan costs and another $40,000 credit for employer contributions to total $44,000 in tax credits for the year.
Automatic Enrollment Tax Credit
The IRS and DOL are also incentivizing startup and existing 401(K) plans to adopt automatic enrollment in their plan design by offering an additional $500 credit per year for the first 3 years that this feature is included in the plan. This credit is only available to employers that have no more than 100 employees with at least $5,000 in compensation in the preceding year. The automatic enrollment feature must also meet the eligible automatic contribution arrangement (EACA) requirements to qualify.
For 401(k) plans that started after December 29, 2022, Secure Act 2.0 REQUIRES those plans to adopt an automatic enrollment by 2025. While a new plan could technically opt out of auto-enrollment in 2023 and 2024, since it’s now going to be required starting in 2025, it might be easier just to include that feature in your new plan and capture the tax credit for the next three years.
Note: Automatic enrollment will not be required in 2025 for plans that were in existence prior to December 30, 2022.
Simple IRA & SEP IRA Tax Credits
Both the Startup Tax Credit and Employer Contribution Tax Credits can also be claimed by companies that sponsor Simple IRAs and SEP IRAs.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
