The tax code typically encourages Americans to save for retirement. It also gives employers incentives to set up retirement plans for their workers. One way it does this is by offering tax credits to offset some of the costs of setting up a retirement plan. Smaller qualifying businesses can cut their taxes by up to $500 by claiming the Credit for Small Employer Pension Plan Startup Costs. A business claims this credit by filing IRS Form 8881 with their tax return.
Qualifying as a small employer
As the name makes clear, the tax credit on Form 8881 is available only to certain “small” employers. A business is eligible for the credit if:
- They had no more than 100 employees who were paid at least $5,000 in the year before it set up the plan. Employees who were paid less than $5,000 don’t count toward the total.
- A business did not previously have a retirement plan in place in the prior 3 years covering substantially the same employees as the plan being set up.
Note that the definition of a small employer for this credit may differ from definitions used elsewhere in the tax code, such as with the Affordable Care Act, where the cutoff is 50 full-time employees. So a business that’s considered a “large” employer under the ACA or other provisions may still qualify for this credit.
Qualifying your plan
Most retirement plans commonly offered by employers qualify as "pension plans" under the rules for the Form 8881 tax credit. These include:
- traditional pension plans, in which employees are guaranteed a specific benefit when they retire
- 401(k) and 403(b) plans
- profit-sharing plans
- money purchase pension plans
- SEP IRAs and SIMPLE IRAs
A business can claim the credit for expenses it incurred to set up a qualified plan. This includes:
- administrative costs
- money spent to educate employees about their benefits and options under the plan
Filling out IRS Form 8881
Form 8881 is a short tax form, with just five lines:
- Line 1: Enter the startup costs for the qualifying pension plan, up to $1,000 maximum.
- Line 2: Enter half of the amount on line 1.
- Line 3: Enter any credit being passed along through an ownership interest in a partnership or S corporation.
- Line 4: Add the amounts from Lines 2 and 3.
- Line 5: Enter the smaller of $500 or the amount on Line 5.
The form then explains how to report the credit amount on Line 5. Which form you report it on depends on the structure of the business.
Using the tax credit
Unlike a tax deduction, a tax credit reduces your income tax liability dollar for dollar. For example, if you have a $1,000 tax deduction, that reduces the amount of income subject to tax by $1,000, producing a tax savings of, at most, a few hundred dollars. A $1,000 tax credit, on the other hand, cuts your taxes by the full $1,000.
However, in some cases a company may save more money by simply deducting their pension plan startup costs as regular business expenses rather than claiming the credit. You can’t do both for the same expenses. Run the numbers both ways and go with whichever saves the most money.