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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