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Running a small business means constantly balancing profitability with the need to attract and retain top talent. One of the most effective strategies to achieve both is by offering a 401(k) retirement plan. Not only does this help your employees save for their future, but it also offers significant tax advantages for your business.
The government offers a wealth of tax incentives that make a 401(k) plan more affordable and accessible, especially for small businesses. Understanding these incentives can help you maximize your tax savings opportunities.
401(k) Tax Credits for Small Businesses
SECURE Act of 2022 (SECURE 2.0) enhanced the tax credits available for small businesses that offer a 401(k) plan. These credits are specifically designed to reduce the financial burden on businesses, making it easier to offer retirement plans to employees.
To qualify for these credits, your business must:
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- Have 100 or fewer employees. You can exclude employees that earned less than $5,000 in the preceding year.
- Have at least one non-Highly Compensated Employee (NHCE) as a plan participant.
- Have not have sponsored a retirement plan for substantially the same employees in the last three years.
For 2024, a Highly Compensated Employee (HCE) is defined as someone who:
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- Owned more than 5% of the business at any time during 2023 or 2024, or
- Earned more than $150,000 in 2023, and if applicable, was in the top 20% of employees when ranked by compensation.
Solo 401(k) plans do not qualify for the small business tax credits since they don’t cover NHCEs.
The SECURE 2.0 tax credits relate to startup costs, employer contributions, and automatic enrollment. Some involved complex calculations. Our 401(k) tax credit calculator can help you estimate your savings.
Qualifying Startup Costs
Small businesses can claim a tax credit for the first three years of a new 401(k) plan to cover startup costs. Qualified startup costs include the necessary expenses incurred to:
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- Establish or administer a 401(k) plan, or
- Educate employees about the plan.
Businesses with 50 or fewer employees can claim a tax credit for 100% of startup costs, up to a maximum of $5,000 per year. Businesses with 51 to 100 employees can claim a tax credit for 50% of startup costs, up to a maximum of $5,000 per year.
Automatic Enrollment
Adding an automatic enrollment feature to a new or existing 401(k) plan can earn your business an additional $500 tax credit per year for the first three years. To qualify, the auto-enrollment feature must meet Eligible Automatic Contribution Arrangement (EACA) requirements.
Employer Contributions
Small businesses can also claim a tax credit for employer contributions made to their 401(k) plan for up to five years. The amount of the credit depends upon the number of employees and the number of years since plan startup. The tax credit is not available for contributions to employees earning more than $100,000 (adjusted for inflation). The limit is $1,000 per eligible employee per year.
The full credit is limited to employers with 50 or fewer employees and phased out for employers with between 51 and 100 employees. The applicable percentage for the credit is:
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- 100% in the first two years,
- 75% in the third year,
- 50% in the fourth year,
- 25% in the fifth year.
401(k) Plan Expenses Are Tax-Deductible
401(k) plan expenses not eligible for a tax credit are tax-deductible as business expenses. These expenses include employer contributions, administrative fees, and employee education costs.
Employer Contributions
Employer contributions made on behalf of employees (including the business owner) are tax-deductible up to 25% of the eligible employees' total compensation. This allows business owners to reduce their taxable income while building their own retirement savings and benefiting employees.
Plan Administration Fees
All 401(k) providers charge fees for plan administration services such as asset custody, participant recordkeeping, ERISA compliance, and investment management. When these fees are paid from a corporate account, not plan assets, their amount is tax-deductible.
Employee Education Costs
Costs associated with educating employees about their retirement plan, such as hosting workshops, webinars, or providing materials to help them understand their investment options, are tax-deductible.
A Win-Win for Business Owners!
Approximately 80% of our small business clients pay 100% of our 401(k) administration fees from a corporate bank account – not plan assets. This approach is popular because it tends to be a win-win for business owners. They can claim a tax deduction for the fees while keeping the portion that would have been deducted from their account earning compound interest until retirement.
The enhanced tax credits provided by SECURE 2.0 make this win-win scenario even more advantageous for the first few years of a new 401(k) plan.
