The term "safe harbor" has a
multitude of meanings in conjunction with the administration of
qualified retirement plans. But in recent years the term has
predominantly been associated with the provisions applicable to
safe harbor 401(k) plans. These plans have become extremely
popular, especially among smaller employers. And when you
consider the overall benefits, it’s no surprise.
One advantage of 401(k) plans to employers is that the
employees bear at least a portion of the cost of their
retirement benefits. A drawback is the rigorous
nondiscrimination testing that must be performed each year, as
well as the possible remedies for a failed test, such as
corrective distributions. A safe harbor plan eliminates the
need for nondiscrimination testing! That alone would justify
the safe harbor option in many situations. But there are other
benefits as well, and you will want to know all of them.
What is a Safe Harbor 401(k) Plan?
The basic principle of a safe harbor 401(k) plan is that a
certain minimum contribution is provided by the employer in
exchange for being able to eliminate deferral (ADP) and matching
(ACP) nondiscrimination testing. The benefit of eliminating the
testing is that highly compensated employees (HCEs)--generally
more than 5% owners and those earning over a specified threshold
in the prior year ($95,000 in 2005)--can defer up to the annual
limit without concern for what the non-HCEs defer.
Under the normal 401(k) plan rules, the average deferral
percentage allowed for HCEs is slightly higher (generally 2%)
than the average percentage deferred by non-HCEs. For 2005, the
maximum deferral allowed per participant is $14,000, with an
additional $4,000 allowed as a catch-up contribution for those
age 50 and older. Consider the following example:
Susanne and Alex each own 50% of the ABC Company which has
three other employees. Susanne and Alex are both under age 50
and earn $100,000 each. In 2004 the three other employees
deferred an average of 5% of compensation into the plan. Using
the prior year testing method, Susanne and Alex, as the only
HCEs, would be allowed to defer an average of 7% into the plan
in 2005, which would be $7,000 each. However, if the plan were a
safe harbor plan, they could each defer the maximum $14,000
since no testing would be required. That’s an additional $14,000
between the two of them!
Establishing the Plan
In general, a safe harbor 401(k) plan must be in effect for
the entire plan year and adopted before the plan year begins. A
midyear adoption is permitted for a new 401(k) plan as long as
the initial plan year is at least three months long. The initial
plan year can be reduced to as little as one month for a newly
established company. Midyear adoption is also permitted for an
existing non-401(k) profit sharing plan that is amended during
the year to include safe harbor 401(k) provisions as long as it
is effective for at least the final three months of the plan
year.
Notice Requirement
Eligible employees must be provided with a safe harbor notice
within a reasonable period before the beginning of the plan
year. The notice is automatically deemed to be timely if it is
distributed at least 30 days and no more than 90 days prior to
the beginning of the plan year.
The notice must contain participants’ rights and obligations
under the plan. It should include the type of safe harbor
contribution being offered, any other contributions to be made,
procedures for making deferral elections, withdrawal and vesting
provisions of the plan as well as other detailed information as
specified in the regulations. Some of the information can be
incorporated by reference to the plan’s summary plan
description.
As an alternative to the standard safe harbor contribution
commitment, a plan can provide that a conditional notice
(referred to as a "maybe" notice) be distributed, stating that
the employer may make a safe harbor nonelective contribution
(discussed below). A follow-up notice is required to be given
out by the beginning of the last month of the plan year stating
whether or not such contribution will be made. If not, the
nondiscrimination tests will have to be performed for that year.
This gives the employer the ability to delay the decision until
the needs of the company can be considered.
Plan Document
When establishing a safe harbor plan, the plan document must
state whether it intends to be a guaranteed safe harbor or a
potential safe harbor that will distribute the "maybe" notice.
It can’t allow for complete flexibility to be dependent upon the
type of notice, if any, that is given out each year.
Safe Harbor Employer Contributions
Employers may choose between two types of contributions: a
safe harbor nonelective contribution or a safe harbor matching
contribution. These contributions must be 100% vested and are
not available for hardship or other in-service withdrawals
before age 59½. No minimum hours of service can be required, and
a participant cannot be required to be employed on the last day
of the plan year.
Nonelective Contribution
The nonelective contribution requires the employer to
contribute 3% of each eligible employee’s compensation for the
year. For an employee’s initial year of participation,
compensation prior to plan entry can be excluded.
The safe harbor nonelective contribution can be made to
another qualified plan maintained by the employer, which must be
stated in the notice.
Matching Contribution
The basic safe harbor matching contribution requires the
employer to match elective deferrals at the following rate: 100%
of the first 3% of compensation deferred, plus 50% of the next
2% deferred.
Alternatively, the employer may contribute an "enhanced"
match which is greater than that required by the basic match.
Under the enhanced match, the contribution rate cannot increase
as an employee’s deferral rate increases, and the contribution
rate for HCEs cannot exceed the contribution rate for non-HCEs.
A plan may allow additional matching contributions on top of
the safe harbor match. The plan will still be exempt from
nondiscrimination testing if the following requirements are met:
- If the additional match is discretionary, it does not
exceed 4% of compensation, and
- The match is not made on deferrals above 6% of
compensation.
Matching contributions that do not meet the safe harbor rules
must be tested, even if the 3% nonelective contribution is made.
The safe harbor match may be discontinued during the year if
a written notice is provided to participants at least 30 days in
advance. In such cases, the plan reverts to non-safe harbor
status and must perform the nondiscrimination tests for the
entire year.
Impact on Other Plan Requirements
Now that you understand how safe harbor plans eliminate ADP
and ACP nondiscrimination testing, you will want to know the
additional advantages they provide in top heavy plans and
cross-tested profit sharing plans.
Top Heavy Plans
A plan is considered top heavy if the account balances of the
key employees (generally owners and certain officers) exceed 60%
of the total account balances under the plan. These plans are
required to provide a minimum employer contribution to all
non-key employees of at least 3% of compensation if any key
employee receives a contribution of 3% or more (including
deferrals).
Plans that meet the safe harbor requirements are exempt from
the top heavy rules unless one of the following applies:
- The employer makes a contribution to the plan other than
deferrals or the safe harbor contribution (such as a
discretionary profit sharing contribution). Additional match
contributions that stay within the safe harbor guidelines
can be made without eliminating the top heavy exemption;
- Forfeitures are allocated as additional contributions
during the plan year; or
- The eligibility requirements for elective deferrals are
more liberal than for safe harbor contributions, so that
some eligible employees do not receive the safe harbor
contribution.
Where the plan does provide more liberal eligibility for
making elective deferrals, nondiscrimination testing must be
performed for the group not eligible for the safe harbor
contribution. If no HCEs are included in this group, the tests
will automatically pass.
Even if a plan is not exempt from the top heavy rules, safe
harbor contributions can be used towards satisfying the top
heavy minimum contribution. In most cases, the 3% nonelective
contribution will satisfy this requirement. If the safe harbor
match is utilized, these contributions can help reduce the top
heavy contribution.
Cross-Tested Plans
An additional benefit of the 3% nonelective contribution is
that it can be used towards the minimum gateway allocation
required in cross-tested plans (also called "new comparability
plans"). These plans factor in participants’ ages and can often
provide a large contribution for certain key participants with
minimal contributions for others.
Here is an example of an ideal situation in which a 3% safe
harbor contribution is used to satisfy the nondiscrimination
requirements, the top heavy requirements and the cross-tested
gateway contribution:
|
Employee |
Compensation |
Deferrals |
3%
Employer Contribution |
Additional Employer Contribution |
Total |
|
Owner A |
$200,000 |
$18,000* |
$6,000 |
$12,000 |
$36,000 |
|
Owner B |
200,000 |
18,000* |
6,000 |
12,000 |
36,000 |
|
Staff C |
50,000 |
? |
1,500 |
0 |
1,500 |
|
Staff D |
40,000 |
? |
1,200 |
0 |
1,200 |
|
Staff E |
30,000 |
? |
900 |
0 |
900 |
| |
$520,000 |
$36,000 |
$15,600 |
$24,000 |
$75,600 |
|
*Includes $4,000 catch-up contribution since over age
50. |
The total employer contribution provides 3% for the staff and
9% for the owners, which satisfies the gateway since the higher
percentage is not more than three times the lower percentage.
This example assumes that the overall contributions satisfy the
cross-testing requirements which are dependent in part on the
ages of the participants.
This plan allows the owners to contribute $72,000 for
themselves at a cost of only $3,600 for their employees, which
is over 95% of the total. Employees can also defer a portion of
their compensation.
The plan will likely be top heavy and is not exempt because
of the additional employer contribution. But the 3% contribution
satisfies the top heavy requirement.
Conclusion
A safe harbor 401(k) plan can provide a variety of benefits
to employers as compared to a traditional 401(k) plan. Employers
who intend to provide some level of matching or profit sharing
contribution may find that a small increase in contributions for
the staff goes a long way. Safe harbor contributions can also be
used to satisfy top heavy as well as cross-tested contribution
requirements. As a result, safe harbor provisions often enable
employers to get the most value out of their 401(k) plans.
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