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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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