Small Employers Not Taking Advantage of Plan Startup Tax Credits—And That’s a Big Problem
Well, this is rather disheartening: Small employers who are starting up retirement plans for their employees are not taking advantage of tax credits specifically created to incentivize them to do so. And most small businesses that do not offer plans are completely unaware that these tax credit incentives that might nudge them to provide one even exist.
Workplace retirement plan industry, we have a problem.
According to a new working paper from the National Bureau of Economic Research, only 5.5% of apparently eligible firms claim the Section 45E credit, which began in the early 2000s as a way to incentivize plan formation and has since been enhanced by the SECURE Act and SECURE 2.0. And that 5.5% is after full policy expansion.
That means five, maybe six new plan sponsors out of every 100 that are eligible are claiming this free money from the government that essentially offsets costs of starting up a plan. Who is advising these plan sponsors, and how are they not making sure they claim this credit?
More bad news is that of the few new plan sponsors that do claim the credit, most only do so for one year despite being eligible to do so for up to three years.
To top it off, the research also found that 72% of small firms that do not currently offer employee-sponsored retirement plans are unaware the tax credit exists in the first place.
With a nod to the 1967 film Cool Hand Luke, “What we’ve got here is failure to communicate.” A bona-fide disconnect between policy intent and real-world application.
Workplace retirement plan industry, we have to do better. We say we need to give the SECURE Act and SECURE 2.0 provisions a chance to work first when telling the federal government America doesn’t need a government-sponsored solution to help close the retirement plan coverage gap (re: Retirement Savings for America Act). But when research like this comes out? Yikes.
Let’s take a closer look at the new paper’s findings.
As the NBER paper points out, policy makers have adopted many measures to incentivize the establishment of employer-sponsored retirement plans (ESRPs), beginning in the early 2000s under Section 45E of the Internal Revenue Code. The incentives became more generous as a result of the original SECURE Act (increased the annual credit to the lesser of $5,000 or $250 per non-highly compensated employee) and SECURE 2.0 (employers with 50 or fewer employees can claim 100% of start-up related expenses, up to $5,000 per year, as a tax credit).
“First, even after the SECURE and SECURE 2.0 Acts substantially increased the credit’s value in 2020 and 2023, respectively, take-up remains very modest. Take-up ranges from 1% of eligible firms (pre-policy expansion) to 5.5% (after full policy expansion),” the paper states.
“We have shown that take-up of the Section 45E credit remains low despite recent increases in generosity,” the paper’s conclusion adds.
The paper also documents evidence of “tax preparer learning,” whereby take-up among a tax preparer’s clients increases after that preparer files their first credit. “Firms with more highly educated owners and whose tax preparer is a CPA are more likely to take up the credit,” per the paper.
But still, the research found that most firms only claim the credit for one year despite being eligible to do so for up to three years.
Not only that, but this also means most startup plans are missing out on the government crediting employer contributions (for the first 5 years, with up to 50 employees) for not having highly compensated employees—up to $1,000 per employee.
As noted ERISA attorney Fred Reish of Faegre Drinker once said about the credit, a small business with 20 employees that sets up a new plan and contributes $1,000 for each of the 20 non-highly compensated employees would get all $20,000 back at the end of the year with this tax credit. You also get back 100% of those contributions after the second year, 75% the third year, 50% the fourth year, 25% the fifth year, and 0% after that.
For the first 2 years, you can set up a plan essentially free from administrative costs and free for employer contributions.
We’ve recently reported on Cerulli data showing that the vast majority of the growth in the number of 401(k) plans in the next 5 years will come from small or micro plans consisting of plans with less than $5 million in assets. Approximately 150,000 new 401(k) plans were added between 2018 and 2023, with nearly two-thirds of these plans added in 2021 and 2023, the Cerulli research revealed. Much of this growth is from employers starting new plans.
Why can’t we get small businesses starting up new plans to take advantage of the tax credits? Chalk it up to combination of a serious lack of awareness, under-informed advisors and tax preparers, and perhaps an overly complex filing process.
So let’s lay it out there again. Per a May 30 IRS update on retirement plan startup tax credits, eligible employers may be able to claim a tax credit of up to $5,000, for 3 years, for the ordinary and necessary costs of starting a SEP, SIMPLE IRA or qualified plan including a 401(k) plan. The tax credit reduces the amount of taxes they may owe on a dollar-for-dollar basis.
Employers can qualify to claim this credit if:
- They had 100 or fewer employees who received at least $5,000 in compensation from you for the preceding year;
- Had at least one plan participant who was a non-highly compensated employee (NHCE); and
- In the three tax years before the first year they are eligible for the credit, their employees weren’t substantially the same employees who received contributions or accrued benefits in another plan sponsored by the employer, a member of a controlled group that includes the employer, or a predecessor of either.
If you are a retirement plan advisor working with small plans and startups, please don’t be part of the problem—be the solution. Put your value on full display by helping small employers take advantage of these tax credits in the way policymakers intended.
SEE ALSO:
• Reish Highlights ‘Remarkable’ Government Incentives in SECURE 2.0
• Micro Plan Market to Account for 9 in 10 401(k)s by 2029: Cerulli
• Tax Credits Under SECURE 2.0 Expand Small Business Coverage
Veteran financial services industry journalist Brian Anderson joined 401(k) Specialist as Managing Editor in January 2019. He has led editorial content for a variety of well-known properties including Insurance Forums, Life Insurance Selling, National Underwriter Life & Health, and Senior Market Advisor. He has always maintained a focus on providing readers with timely, useful information intended to help them build their business.
