Congress understands the effectiveness of 401(k) plans in helping participants reach their retirement savings goals.  As such, in 2001 as part of a new law, they created a tax credit of up to $1,500 ($500 per year for three years) for small employers who start 401(k) plans to help defray the costs of starting and administering the plan.

Here’s how it works.

For costs paid or incurred in tax years beginning after December 31, 2001, for retirement plans that first become effective after that date, you may be able to claim a tax credit for part of the ordinary and necessary costs of starting a SEP, SIMPLE, or qualified plan (including a 401k). The credit equals 50% of the cost to set up and administer the plan and educate employees about the plan, up to a maximum of $500 per year for each of the first three years of the plan. For plans that become effective after 2002, you can choose to start claiming the credit in the tax year before the tax year in which the plan becomes effective.

You must have had 100 or fewer employees who received at least $5,000 in compensation from you for the preceding year. At least one participant must be a non-highly compensated employee. The employees generally cannot be substantially the same employees for whom contributions were made or benefits accrued under a plan of any of the following employers in the three-tax-year period immediately before the first year to which the credit applies. 

  1. You.
  2. A member of a controlled group that includes you.
  3. A predecessor of (1) or (2).

The credit is part of the general business credit, which can be carried back or forward to other tax years if it cannot be used in the current year. However, the part of the general business credit attributable to the small employer pension plan start-up cost credit cannot be carried back to a tax year beginning before January 1, 2002. 

To take the credit, contact your tax advisor or obtain Form 8881, Credit for Small Employer Pension Plan Start-Up Costs, and the instructions.