Startup tax credit

What the startup tax credit is

Section 45E of the tax code gives small employers a credit for the ordinary costs of setting up and administering a new retirement plan and educating employees about it. SECURE 2.0 enlarged it from 2023.

You qualify if you had 100 or fewer employees who earned at least $5,000 in the prior year, the plan covers at least one non-highly compensated employee (NHCE), and you did not maintain a plan for substantially the same employees in the previous three years.

The credit for startup costs is, each year for three years:

• 100% of eligible costs for employers with 50 or fewer employees, 50% for those with 51 to 100.

• Capped at the greater of $500, or the lesser of $250 per eligible NHCE or $5,000.

The credit for employer contributions

A second credit covers employer contributions to a new defined contribution plan, up to $1,000 per employee, for five years: 100% in years one and two, then 75%, 50% and 25%. It is reduced for employers with 51 to 100 employees and is not available for contributions to employees paid above an indexed limit ($110,000 for 2026).

Example

A 20-person company starts a 401(k) in 2026. All 18 non-owners are eligible NHCEs, so the cap is the lesser of $4,500 or $5,000. The company pays $3,200 in plan costs and claims a $3,200 credit. It also matches $1,500 for an employee paid $65,000 and claims $1,000 for that employee.

Common mistakes

• Deducting the same costs you claimed as a credit.

• Counting an owner-only plan. Without an NHCE there is no credit.

• Forgetting that related businesses count toward the employee limits.

• Not filing Form 8881. The credit is not automatic.

• Missing the option to start the three years in the tax year before the plan takes effect.