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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