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Start-Up Retirement Plan Tax Credits: A Guide for CPAs Advising Small Business Clients

The Startup Cost Credit Under IRC Section 45E.

The startup cost credit under IRC Section 45E is designed to reimburse eligible small employers for the expenses of establishing and administering a new retirement plan. As originally enacted, the credit equaled 50% of qualified startup costs, subject to an annual cap of $500, available for three taxable years.

The SECURE Act of 2019 significantly expanded the credit. The annual cap was raised to the greater of $500, or the lesser of (a) $250 multiplied by the number of non-highly compensated employees (“NHCEs”) eligible to participate in the plan, or (b) $5,000. This means an eligible employer can claim up to $5,000 per year for three years, or up to $15,000 over the full credit period.

SECURE 2.0, effective for tax years beginning after December 31, 2022, further enhanced the credit by increasing the applicable percentage from 50% to 100% of qualified startup costs for employers with 50 or fewer employees who received at least $5,000 in compensation in the tax year preceding the first credit year. Employers with 51 to 100 such employees remain at the original 50% rate. Because the credit percentage doubled for the smallest employers, a qualifying employer with sufficient startup costs can now claim the full $5,000 annual credit without needing to incur $10,000 in expenses to reach it.

The three-year credit period begins with the taxable year in which the plan becomes effective. However, the employer may elect to treat the preceding taxable year as the first credit year, which can be advantageous when startup costs are paid or incurred in that preceding year. Qualified startup costs include ordinary and necessary expenses paid or incurred to establish or administer an eligible employer plan and to educate employees about the plan. These costs are claimed on IRS Form 8881, Part I.

To be eligible, the employer must have had no more than 100 employees who received at least $5,000 in compensation in the tax year preceding the first credit year, must have at least one NHCE eligible to participate, and neither the employer nor a related or predecessor employer may have established or maintained a qualified employer plan under which contributions were made or benefits accrued for substantially the same employees during the three tax years preceding the first credit year. Employer size eligibility must also be satisfied in subsequent credit years, subject to applicable grace periods. Controlled groups, common-control entities, and affiliated service groups are treated as a single employer for purposes of both the employee count and the credit computation. Importantly, the employer’s otherwise allowable deduction for plan expenses must be reduced by the amount of the credit claimed. An employer may elect not to claim the credit if the deduction is more beneficial.

The Employer Contribution Credit.

SECURE 2.0 also added IRC Section 45E(f), which provides a separate credit for employer contributions to eligible employer plans other than defined benefit plans. This credit is effective for tax years beginning after December 31, 2022, and is designed to incentivize small employers to make employer contributions, such as matching or nonelective contributions, during the early years of a plan’s existence. The employer-size and prior-plan restrictions described above also apply, using the plan’s effective year as the first credit year. Contributions count for the tax year for which they would be deductible under IRC Section 404, including qualifying contributions made by the return due date with extensions.

The credit equals an applicable percentage of employer contributions (excluding elective deferrals), subject to a maximum of $1,000 per employee per taxable year. The applicable percentage phases down over a five-year period beginning with the tax year in which the plan becomes effective: 100% in Years 1 and 2, 75% in Year 3, 50% in Year 4, and 25% in Year 5. The full credit is available only for employers with 50 or fewer employees who received at least $5,000 in compensation in the preceding tax year. For employers with 51 to 100 such employees, the credit amount (after applying the $1,000 per employee limit) is reduced by 2% for each employee in excess of 50, eliminating the credit at 100 employees.

No credit is available for contributions made on behalf of an employee who receives more than $110,000 in FICA wages from the employer during the 2026 tax year. This threshold is indexed for inflation. As with the startup cost credit, controlled groups and affiliated service groups are treated as a single employer.

The Auto-Enrollment Credit.

A separate $500 annual credit is available for three consecutive taxable years, beginning with the year an employer first includes an Eligible Automatic Contribution Arrangement (“EACA”) in a new or existing qualified employer plan, provided the employer maintains the EACA in subsequent credit years. The employer must have no more than 100 employees who received at least $5,000 in compensation in the year preceding the first credit year. Unlike the startup cost credit, the auto-enrollment credit does not require that at least one NHCE be eligible to participate in the plan.

CPAs should note that new 401(k) and 403(b) plans established on or after December 29, 2022 are generally required to include an EACA for plan years beginning after December 31, 2024. Exceptions include employers normally employing 10 or fewer employees and businesses in existence for less than three years. As a result, many newly established plans may qualify for this credit, provided they meet the employer size and other eligibility requirements. Employers adding an EACA to an existing plan may also be eligible.

Stacking Credits and Practical Considerations.

These credits can generally be stacked. An eligible employer that establishes a new plan with an EACA can combine the startup cost credit (up to $5,000 per year) and the auto-enrollment credit ($500 per year), yielding up to $5,500 per year for three years. The employer contribution credit operates separately and can provide up to an additional $1,000 per eligible employee per year during its five year phase-down period. For a small employer with 10 eligible employees, the combined credits can total tens of thousands of dollars over the first several years of the plan.

Several practical considerations merit attention. First, these credits are nonrefundable general business credits under IRC Section 38. An employer with little or no federal income tax liability in a given year may not be able to use the full credit amount. However, unused general business credits may generally be carried back one year and carried forward 20 years, subject to the applicable limitations. Second, the otherwise allowable deduction for startup costs and employer contributions must be reduced by the corresponding Section 45E credit amount, or a client may instead elect to not claim the credit. Third, controlled groups, common-control entities, and affiliated service groups are treated as a single employer for purposes of both the employee-count thresholds and credit computations, which can affect eligibility for employers that are part of a larger group.

CPAs working with clients setting up a new plan should coordinate with the client’s third-party administrator and ERISA counsel to ensure that plan design supports credit eligibility, and that the necessary elections and filings are made in a timely manner.

Jesse St. Cyr, Partner, Poyner Spruill
Jesse is a member of the Employee Benefits and Executive Compensation team at Poyner Spruill LLP. He represents clients before the IRS and DOL in matters involving employee benefits. Jesse has experience working with a diverse range of benefits and compensation matters and has extensive experience working with a variety of employers. Jesse is recognized by Chambers USA as a leading lawyer for Business (Employee Benefits & Executive Compensation).