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In today’s competitive job market, offering a retirement plan can be a game-changer for small businesses looking to attract and retain top talent. However, the costs associated with setting up and maintaining these plans can be a significant barrier. Fortunately, the Internal Revenue Code (IRC) provides financial relief through Section 45E, which offers a tax credit for employer contributions to newly established retirement plans. This article outlines the key details of the Section 45E credit, including retirement plan qualifications, employer eligibility, contribution guidelines, phase-out rules, and how this credit fits within the general business credit framework.
Retirement Plan Qualifications
To qualify for the Section 45E credit, the retirement plan must be a newly adopted qualified defined benefit or defined contribution plan, such as a 401(k), SIMPLE IRA, or Simplified Employee Pension (SEP) plan. The plan must not have been in place in the three tax years preceding the year it becomes effective. This requirement ensures that the credit incentivizes the establishment of new retirement plans rather than subsidizing existing ones.
Employer Qualifying Contributions
The Section 45E credit is designed to offset employer contributions to new retirement plans, including both matching and nonelective contributions. These contributions must be made to an eligible employer plan, excluding defined benefit plans. The credit is calculated as a percentage of employer contributions, up to a maximum of $1,000 per employee. Contributions for employees earning more than $100,000 in wages (adjusted for inflation after 2023) are not eligible.
Employer Eligibility
To qualify for the Section 45E credit, an employer must have 100 or fewer employees who earned at least $5,000 in compensation during the preceding tax year. Additionally, the employer must not have established or maintained a qualified employer plan for substantially the same employees in the three tax years before implementing the new plan.
Phase-Out Based on Number of Employees
The tax credit phases out based on the number of employees. Specifically, the credit amount is reduced by 2% per employee once an employer has more than 50 employees who earned at least $5,000 in the previous tax year. This phase-out mechanism ensures that the credit primarily benefits smaller businesses, which often face greater financial challenges in setting up retirement plans.
Employee Qualifications
Employees must have received at least $5,000 in compensation from the employer in the preceding tax year to qualify for contributions under the Section 45E credit. This requirement ensures that the credit supports contributions for employees who are actively engaged in the business and earning a meaningful income.
Phase-Out of Credit Over Five Years
The Section 45E credit is available for a total of five years, with a gradual phase-out:
Years 1 & 2: 100% of qualifying contributions (up to $1,000 per employee)
Year 3: 75% of contributions
Year 4: 50% of contributions
Year 5: 25% of contributions
This structured phase-out encourages employers to continue contributing to employee retirement plans while gradually reducing reliance on the credit.
Part of the General Business Credit
The Section 45E credit falls under the general business credit, meaning it is subject to specific tax rules and limitations. Employers can carry back unused credits for one year and carry them forward for up to 20 years, providing flexibility in maximizing tax benefits over time.
Effective Years
Amended by the SECURE 2.0 Act, the Section 45E credit is effective for tax years beginning after December 31, 2022. Employers can begin claiming the credit for qualifying contributions made in 2023 and beyond. The recent amendments have increased the credit percentage for small businesses with 50 or fewer employees, making it an even more attractive incentive to establish retirement plans.
Encouraging Employers Without a Pension Plan
For small business owners who have not yet implemented a pension or retirement plan, the Section 45E credit provides a compelling reason to do so. By alleviating the financial burden of employer contributions, this credit makes it more feasible to offer retirement benefits that enhance employee satisfaction, retention, and overall business competitiveness.
How TPSA CPAs Can Help
The Section 45E tax credit offers a valuable opportunity for small businesses to establish and fund employee retirement plans with financial support. By understanding the eligibility requirements, qualifying contributions, and phase-out mechanisms, employers can take full advantage of this tax incentive. As part of the general business credit, the Section 45E credit provides long-term tax benefits and flexibility. With the enhancements introduced by the SECURE 2.0 Act, now is the perfect time for businesses to explore retirement plan options.
Contact our office today to learn more about how the Section 45E tax credit can benefit your business and help you establish a competitive retirement plan for your employees.