Federal Tax Incentives Encourage Small Business Retirement Plans

by Michael S. Donnelly, AAMS®, RFC®

Federal tax incentives that directly encourage small business retirement plans, while also reducing complexities that made plans costly or difficult to operate. Here's what you need to know about tax incentives for small business retirement plans.

Too often, workers in small companies are much less likely to have retirement plan coverage on the job. The reasons are varied and complex, but they boil down to one basic problem. Many small companies don’t think they can afford retirement plans.


The U.S. Congress has addressed this attitude head-on by creating federal tax incentives that directly encourage small business retirement plans, while also reducing complexities that made plans costly or difficult to operate. As a result, the gap in plan participation between workers in big companies and small companies is starting to shrink.


Whether you own a small company or work as an employee in one, you should know about three basic areas of changes: 1) federal tax credits; 2) enhancements to SIMPLE plans; and 3) other incentives that make small business retirement plans more attractive.

Federal Tax Credits


Congress has created two federal tax credits related to retirement plans. One is specifically designed for companies with 100 or fewer employees that start new plans. These companies are eligible for a tax credit to offset a portion of administrative and participant education costs during the first three years of the plan’s life. The credit is 50% of the qualifying starup costs up to a maximum of $500 per year for each of the first 3 years of the plan.


The second tax credit is available for low-income and middle-income participants in qualified retirement plans of all types and sizes, including 401(k)s, SIMPLEs, Traditional IRAs and Roth IRAs. Taxpayers can receive a “government matching” credit on up to  $2,000( if filing jointly ) of their own money they contribute to a plan. The credit is a percentage of the qualifying contribution amount and applies to individuals with a filing status and income of:

• Single, married filing separately, or qualifying widow(er), with income up to $27,750


• Head of Household with income up to $41,625


• Married Filing Jointly, with incomes up to $55,500


Enhancements to SIMPLEs

The SIMPLE, a type of retirement plan created specifically for small companies, was introduced by Congress in 1997.


The major advantage of SIMPLEs for companies is simplicity. By agreeing to make minimum contributions on behalf of all eligible workers, the company is relieved of responsibility for performing complex non-discrimination testing or complying with cumbersome “top-heavy” rules. When the SIMPLE plan is set up with personal IRAs as funding vehicles, the company also has no ongoing investment responsibility. After the first two years of participation, employees are free to transfer from the SIMPLE’s IRA into another IRA of their choice, if they wish, with no tax consequence or penalty. (A 25% premature distribution penalty applies on transfers in the first two years.)


Other Enhancements


Several other incentives in U.S. tax law have encouraged small companies to set up plans. A variety of funding limits have been gradually raised, ranging from 401(k) deferral limits to the formula for calculating defined benefit plan contributions. In general, small business owners will have more freedom to sock money away for their own retirements, with tax advantages. The top-heavy rules that have added red-tape for thousands of small companies in the past have been relaxed, too. Now, any matching contributions made by the company will count toward the minimum contributions required in top-heavy plans. In the future, it will be easier for workers to take their plan money with them from job-to-job, or else transfer it into a personal IRA.


Now is a good time to review the many good reasons to create or participate in a retirement plan with the help of a qualified financial professional. The barriers that have prevented so many small companies from offering plans are falling. The opportunities of all workers to set money aside for the future, with tax advantages, have never been greater.

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