For the S-Corp business owner it is smart idea to consider setting up a retirement plan such as a 401k. If you want to attract the best employees you need to offer a competitive compensation package. This not only includes a salary but a benefits package as well.
It’s great when the IRS allows an S-Corp small businesses to offer their employees a benefit and still receive a tax deduction. The credit for small employer pension plan start-up costs does just that. It covers two types of expenses: retirement plan set up costs and employer contributions. Let’s walk through what is available and how you can qualify.
Qualified Set Up Costs
There is a cost to setting up a 401(k) plan. Thankfully there is a retirement plan tax credit for the related expenses. The tax credit consists of:
1) The start-up costs for setting up the 401k
and
2) Employer Contributions to the 401k
401k plans are typically set up through third-party administrators. These companies will make sure that the retirement plan is in compliance. They also help in providing employees with retirement related education. For this, and to cover their ordinary and necessary costs, they charge a fee. You can expect an initial fee to get 401k plan documents in order as well as an annual administrative fee to cover ordinary and necessary costs.
A 401k plan may differ based on what is offered. One company may offer a match where the employer will add money to the employee’s retirement account dollar-for-dollar based on a certain percentage. If an employee contributes 3% from their paycheck towards their 401k retirement plan the employer will also add 3%. The company gets a deduction for this matching contribution and it also encourages the employee to put money away for their retirement.
Some 401k plans can be set up to allow employees to borrow from the money in their account. There are rules as to how much can be borrowed and when the loan from the 401k must be paid back.
These factors will all go into determining how much the startup costs will be to get the 401k up and running.
Employer Contributions
Thanks to the SECURE Act of 2022 an S-Corp owner can also take advantage of the retirement plan tax credit through employer contributions. The law was passed with the intent of encouraging employers to assist their employees in saving for retirement. It limits highly compensated employees by capping the credit to only those who earn $100,000 or less in wages. The credit for employer contributions is also limited to $1,000 per employee.
Let’s look at an example.
Fred owns Bedrock Construction and has 3 employees, Barney, Betty and Dino. None of them are considered a highly compensated employee as they all earn less than $100,000. His old boss, Mr. Slate, encourages Fred to set up a 401k plan for his company. He agrees and incurs $5,000 in fees to start the retirement plan. To show his appreciation for their hard work Fred decides to contribute $2,000 to each of their 401k accounts. Bedrock Construction is eligible for a credit of $8,000 ($5,000 for the qualified startup costs plus $3,000 or $1,000 per employee).
How Much is the Credit for Setting Up a 401k?
The good news is that as of January 1, 2023 an eligible employer may deduct 100% of the expenses associated with setting up the 401k plan. An eligible employer is one that has no more than 50 employees and compensation from them is at least $5,000. (Employers with more than 50 employees get to take the credit but only up to 50% of the startup expenses).
The deduction is taken over the first 3 years and is limited to the greater of:
1) $500
or
2) The lesser of $5,000 or $250 per eligible employee who is not considered highly compensated
Taking the Credit
The credit is taken on Form 8881 of your federal tax return. It should be noted that although the employer contribution portion of the tax credit can be taken over the first 5 years more of the credit is allowed in earlier years. For example, the “applicable percentage” of employer contributions available for the credit is 100% in the first 2 years, 75% in year 3, 50% in year 4 and 25% in year 5.
If you set up the retirement plan for automatic enrollment a tax credit of $500 per year is available for the first 3 years.
Take Advantage of the Retirement Plan Tax Credit
Your S-Corp can take advantage of the tax credit available by offering a 401k or similar retirement plan. The tax credit can be used to offset startup costs for the first three years of the 401k. Typically, contributions that the employer makes into the account for his or her employees are eligible up to a maximum credit of $1,000 per employee.
A retirement plan is a great way for small businesses to increase the total compensation of their employees while also receiving tax benefits. Run the numbers and speak with the a tax advisor to see how you can take advantage of this.