If you missed the first six parts of our guide to deductible business expenses, you can find them below:
As a business owner, you have likely found that offering various employment incentives helps to attract and retain high-quality employees. Offering an employer-sponsored retirement plan is a popular incentive among many employers, with tax benefits to boot. You may choose to offer either a defined benefit plan (also known as a pension plan) or a defined contribution plan.
Defined benefit plans, more commonly known as pension plans, promise a specified monetary amount upon an employee’s retirement, with a few payment options to choose from: a lump sum, single-life annuity, or qualified joint and survivor annuity.
Defined contribution plans are comprised of a number of investments. Rather than promising a specified payment amount upon retirement, retirement benefits depend on how much money is contributed by the employer and the employee, as well as how the plan’s underlying investments perform.
Because employers are responsible for contributing the promised funds to an employee’s pension plan, the financial risk lies solely with the employer. Pension plans can be complex and expensive for employers compared to defined contribution plans, in which the employee shoulders the financial risk of their plan’s underlying investments. These factors lead most employers to opt for defined contribution plans such as a 401(k), employee stock ownership plan, or profit-sharing plan. As defined contribution plans have risen in popularity in recent decades, pension plans have largely fallen out of use.
Deducting Employer Contributions
To incentivize employer-sponsored retirement plans, the IRS offers tax incentives to employers who offer a 401(k) or other retirement plan to their employees. Employers may deduct contributions to defined contribution plans, but the deduction is limited to 25% of the compensation paid to eligible employees participating in the plan (up to $285,000 for each employee).
If your retirement plan contributions exceed the amount you can deduct for that tax year, you may carry over the difference to deduct in later years.
Where to Deduct Employer Contributions
To deduct contributions made to employees’ retirement plans, sole proprietors should include the expenses on their Schedule C. Partnerships should report these contributions using Form 1065, and corporations should use Form 1120 or 1120-S.
Sole proprietors and partners may deduct contributions to their own retirement plans, as well; sole proprietors should include this amount on line 15 on their Schedule 1, while contributions for partners should be included on their K-1.
Deducting pension plan contributions is a complex process that requires the aid of an actuary.
Deducting Administrative Fees
Administrative fees associated with an employer-sponsored retirement plan may also be tax-deductible, so long as the fees are paid by the business owner or corporate accounts. However, administrative fees paid from plan assets are not considered tax-deductible.
If trustees’ fees are not covered by contributions to a retirement plan, those expenses may also be deducted.
Tax Credit for Retirement Plan Startup Costs
In addition to deductible contributions and administrative fees, the IRS offers a tax credit to help business owners offset the costs of setting up a retirement plan for their employees. Though called the Credit for Small Employer Pension Plan Startup Costs, this credit is not restricted to employers offering traditional pension plans; employers offering a SIMPLE IRA, SEP IRA, 401(k), or other qualified plan are also eligible for this tax credit if they meet the following criteria:
During the year before the retirement plan was set up, the business had no more than 100 employees, each of whom received at least $5,000 in compensation.
The plan had at least one participant considered a non-highly compensated employee (NHCE) as defined by the IRS.
The business did not offer a retirement plan during the 3 years prior to offering the new plan that covered substantially the same employees as the plan being set up.
Eligible employers may claim the credit for 50% of eligible startup costs up to $5,000 for the first three years of the plan. Costs of setting up, administering, and educating employees about the plan are eligible for the tax credit.
Note that if you claim this tax credit for startup costs, you may not deduct the same expenses.
Small Employer Auto-Enrollment Credit
If you add an auto-enrollment feature to an employer-sponsored retirement plan, you may claim a credit of $500 per year for 3 years, starting with the first year you offer auto-enrollment.
Employers can claim these tax credits using Form 8881.
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