How 401k Reimbursement Works Through Business Tax Credits

The term “401k reimbursement” is not a standard industry phrase. For employees, contributions to a 401k are salary deferrals, where a portion of their paycheck is directed into a retirement account before taxes are calculated. For small business owners, however, the idea of reimbursement aligns with tax credits from the federal government designed to offset the expenses of establishing and funding a new 401k plan.

Tax Credits for Plan Startup and Administrative Costs

The SECURE Act and its successor, the SECURE 2.0 Act, introduced tax incentives for small businesses to reduce the financial burden of offering retirement plans. The primary incentive is a tax credit that covers the ordinary and necessary costs of starting and administering a new plan. This includes expenses like setup fees, costs for administering the plan, and fees for educating employees.

To be eligible for this startup cost credit, a business must have 100 or fewer employees who earned at least $5,000 in compensation during the preceding year. The plan must cover at least one non-highly compensated employee (NHCE). Furthermore, the employer cannot have sponsored a substantially similar retirement plan for the same employees within the three tax years prior to establishing the new plan.

The credit calculation provides the most benefit to the smallest businesses. For employers with 50 or fewer employees, the credit covers 100% of qualified startup costs; for businesses with 51 to 100 employees, it covers 50%. The credit is available for the first three years of the plan and is subject to an annual limit, which is the greater of $500 or $250 for each non-highly compensated employee, up to a maximum of $5,000.

An additional credit of $500 per year for three years is available to small businesses that include an automatic enrollment feature in their 401k plan. This feature automatically enrolls employees unless they opt out. This credit can be claimed for adding the feature to either a new or an existing plan.

Tax Credit for Employer Contributions

The SECURE 2.0 Act also introduced a tax credit to incentivize employers to make contributions to their employees’ accounts, such as through a matching program or profit sharing. This credit is separate from the one for startup costs and is specifically tied to the money a business puts into the plan for its workers.

The credit is available for the first five years of a new plan and is calculated based on employer contributions. The credit is capped at $1,000 per employee per year. To be eligible, contributions must be for employees who earn no more than $100,000 annually, an amount that is indexed for inflation.

The amount of the credit is a percentage of the employer’s contribution that decreases over five years. For businesses with 50 or fewer employees, the credit is 100% of contributions in the first and second years, 75% in the third year, 50% in the fourth, and 25% in the fifth. For businesses with 51 to 100 employees, this credit is reduced, as the applicable percentage is lowered by 2% for each employee over 50.

How to Claim the Tax Credits

Claiming these tax credits is handled through a business’s annual tax filing. Both the startup cost and employer contribution credits are claimed on the same document: IRS Form 8881, Credit for Small Employer Pension Plan Startup Costs.

When filing, the business must complete and attach Form 8881, providing information on the plan, number of employees, qualified startup costs, and total employer contributions. A business cannot claim a tax credit and also deduct the same expenses.

After calculating the total credit amount, the final figure is transferred to the business’s main income tax form, such as Form 1120 for corporations or Form 1040 for sole proprietorships. This credit directly reduces the business’s tax liability. Proper documentation of all startup costs and employer contributions should be maintained to support the claim.