One of the more
frustrating aspects for the small business maintaining a 401(k) plan
is satisfying the special nondiscrimination requirements. The tests
require adequate participation by "non-highly compensated employees"
(NHCEs) in order for the "highly compensated employees" (HCEs) to
maximize their own salary deferrals. Failure to satisfy the tests
requires a correction which often means the painful process of
returning salary deferrals to the HCEs.
For a number of years, employers have had the option to simplify
this process and avoid the tests altogether by providing a "safe
harbor" contribution for NHCEs. Beginning in 2008, plans that use
automatic enrollment have a new, somewhat more flexible, safe harbor
option.
To help those employers still struggling with the nondiscrimination
tests or for those who have chosen a safe harbor design and would like
to consider the new option, this article will review and contrast the
various safe harbor options that are now available, as well as discuss
automatic enrollment as a method of solving testing problems.
Testing Requirements
Absent a safe harbor contribution, a 401(k) plan must satisfy the
ADP test each plan year. This requires calculating each eligible
participant’s deferral percentage and comparing the average percentage
of the HCEs to the average percentage of the NHCEs. HCEs are employees
who:
- Owned more than 5% of the employer in the current or previous
year, or
- Earned more than a specified limit in the previous year
($100,000 for 2007).
Employer matching contributions and after-tax employee
contributions must satisfy a similar ACP test. Failure to satisfy
either test requires either returning excess deferrals or
contributions to the HCEs (within 2½ months of the end of the plan
year) or making additional employer contributions (within 12 months
after the end of the plan year).
In addition, a "top heavy plan" (more than 60% of the benefits
under the plan belong to "key employees") must satisfy special
contribution requirements. Even if the sponsor makes matching
contributions, additional top heavy contributions may have to be made
to ensure that all non-key participants receive the required
contribution which, in most cases, is 3% of compensation.
Traditional Safe Harbor Options
If a qualifying safe harbor contribution is made to a 401(k) plan,
the plan is deemed to satisfy the ADP test. This means the HCEs may
make the maximum allowable deferral of compensation ($15,500 in 2008
plus $5,000 catch up contribution if age 50 or over).
In most cases the ACP test is also avoided and the plan is deemed
to have satisfied the top heavy requirements. The safe harbor
contributions must be 100% vested and are not available for hardship
or other in-service withdrawals before age 59½.
The employer must adopt a safe harbor provision prior to the
beginning of the plan year. Also, participants must be notified of the
employer’s intent to make safe harbor contributions within 30 to 90
days prior to the beginning of the plan year. There are several types
of employer contributions that can satisfy the safe harbor.
Nonelective Contributions
One option is to make a 3% nonelective contribution for all NHCEs
eligible to participate in the plan. Contributions must be made for
all eligible participants regardless of whether the participant has
worked 1,000 hours during the year or was employed on the last day of
the plan year.
Matching Contributions
As an alternative, the employer can make a basic matching
contribution for all eligible NHCEs who choose to make salary
deferrals at the following rate: 100% of the first 3% of compensation
deferred, plus 50% of the next 2% deferred. The sponsor may contribute
an "enhanced" match equal to at least the amount of the basic match
(e.g., 100% of the first 4% deferred). 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 the NHCEs.
Qualified Automatic Contribution Arrangement
For plan years beginning in 2008, the Pension Protection Act
established a "qualified automatic contribution arrangement (QACA)
that acts as an additional type of safe harbor design (meaning the
plan automatically satisfies the ADP and ACP tests as well as top
heavy requirements).
Under a QACA, an eligible employee automatically has a specified
percentage of compensation withheld unless he makes an affirmative
election either not to participate or to change the amount of the
default election. A QACA can allow automatic deferrals of up to 10% of
compensation but, as a minimum, the plan must require automatic
deferral of 3% the first year, 4% the second, 5% the third and 6%
thereafter.
The employer can make either:
- A 3% nonelective contribution for each NHCE, or
- A match contribution of 100% of the first 1% deferred and 50% of
the next 5% deferred.
Unlike the traditional safe harbor design, contributions do not
have to be fully vested until an individual has earned two years of
service.
A QACA is similar to a traditional safe harbor design in several
respects. Contributions are required to be subject to withdrawal
restrictions and cannot be restricted to those meeting an eligibility
requirement (1,000 hours of service or employment on the last day of
the plan year). Also the same rules apply concerning the timing of the
plan amendment and annual notice to participants about the safe harbor
contributions.
There is also an annual required notice about the automatic
enrollment feature that must notify participants of:
- The level of elective contributions under the default;
- The employee’s right to elect out of or change the amount of the
deferral election; and
- How contributions will be invested in the absence of an employee
investment election.
Choosing a Safe Harbor Option for the First
Time
A 401(k) plan sponsor struggling with testing issues should
seriously consider one of the safe harbor designs. An employer
reluctant to make the required contributions should also consider
automatic enrollment (without a safe harbor contribution) as a method
to increase participation and thereby improve test results.
Automatic Enrollment
Based on evidence that automatic enrollment can increase
participation significantly, the Pension Protection Act included
several automatic enrollment options to encourage this practice. The
concept is simple: automatic enrollment brings in those who fail to
participate simply because of inertia. This is likely to have the
biggest impact on the young, a group that benefits the most from
compounding returns over an accumulation period of 30 years or more.
An "eligible automatic contribution arrangement" (EACA), which is
also new for 2008, can be an effective approach that does not require
a safe harbor contribution. With an EACA, the sponsor sets the default
deferral percentage at any level and does not have to increase it each
year as under a QACA.
The program requires the use of a qualified default investment
arrangement, and the sponsor has the option to allow new enrollees the
option to withdraw contributions within 90 days of enrollment. The
EACA has one other advantage: the 2½ month correction period under the
ADP and ACP tests is extended to 6 months.
Electing a Safe Harbor Design
Other employers will want to consider adopting either a traditional
safe harbor or QACA. It’s important to understand that each of these
options provides the sponsor design flexibility. In addition to the
safe harbor contribution, the sponsor can make an additional
discretionary matching contribution and still avoid the ACP test as
long as certain requirements are met.
It can also be meaningful that the safe harbor options, in most
cases, eliminate the complication of any top heavy problems. However,
if the plan uses a matching contribution to satisfy the safe harbor
and any other employer contributions are made, the plan must still
demonstrate compliance with the top heavy rules.
When selecting one of the options there are several clear
differences between the traditional safe harbor and the new QACA.
First, the QACA does not require immediate full vesting—two years of
service can be required. Second, the maximum required matching
contribution is effectively 3.5% of compensation and not 4%. This can
reduce the employer’s contribution cost somewhat, but this advantage
may be offset by a higher rate of participation under a plan that has
automatic enrollment.
Plans Currently Using a Safe Harbor Design
If an employer is currently using a traditional safe harbor design
with the 3% nonelective contribution, a QACA with a nonelective
contribution is a good alternative. The contribution cost is the same,
but added participation means more retirement security. Some employers
will appreciate the ability to have a vesting provision, although
changing the vesting provision does complicate administration.
As discussed above, a QACA with a matching contribution may be more
or less expensive than the current safe harbor, depending upon the
circumstances. If the safe harbor plan currently has a high level of
participation or if it is not expected that automatic enrollment will
have much of an impact on participation levels, then the QACA safe
harbor contribution will cost less than the traditional approach. Even
if the cost is a bit more, due to increased participation, an employer
motivated by the other benefits of automatic enrollment may still
choose to switch.
Finally, note that an employer that appreciates the benefits of
automatic enrollment but is satisfied with the current safe harbor can
also choose to add an automatic enrollment feature and maintain the
current safe harbor design.
Conclusion
With the introduction of new options, it is a good time for a
401(k) plan sponsor to review current plan design. Testing problems
can now be addressed with automatic enrollment either with or without
a safe harbor contribution. Some employers concerned about the
retirement preparedness of employees may choose to add automatic
enrollment, even if the plan doesn’t have testing problems.
Current safe harbor designs should also be reviewed to determine
whether it’s appropriate to switch to the QACA approach, either as a
way to save on the cost of the required contribution, the ability to
have vesting or simply out of concern for the well-being of the
participants.
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