Safe-Harbor 401(k)s Attractive to Both Sponsors and Participants

A plan without a safe-harbor is subject to average deferral percentage (ADP) and average contribution percentage (ACP) testing requirements, notes Jason Gross, Ubiquity Retirement + Savings’ director of National Sales and Development, based in Chicago.

In many cases, the average deferral percentage for non-highly compensated participants limits the amounts highly-compensated participants can contribute to a 401(k). “This can be problematic, especially with a small business,” Gross says.                 

To remedy this, the Internal Revenue Service (IRS) allows for a safe-harbor plan design which requires committed employer contributions in exchange for eliminating nondiscrimination testing requirements. Steve Friedman, shareholder at Littler Mendelson and co-chair of the Employee Benefits Practice, based in New York City, adds that a requirement is that contributions employers make are fully vested the date they go into the plan.

Gross explains that, under the safe-harbor plan rules, plan sponsors could make a non-elective contribution equal to at least 3% of all compensation for all non-highly compensated employees eligible to participate, regardless of whether they made any elective deferrals. Alternatively, an employer could agree to provide a 100% match on employees’ effective contributions up to 3% of compensation, and a 50%-minimum match on employee elective contributions up to the next 2% of compensation. Gross says the latter is the most popular option.

Plan sponsors may also use an enhanced match formula of 100% of the first 4% of pay that is contributed to the plan (this is the minimum required under this option), and 100% of the first 6% of pay is the maximum allowed to still get a pass on the ACP test.

If plan sponsors get into a financial bind with the cost of offering these plans, the IRS has issued rules for relief.

The deadline to adopt a new safe-harbor plan is October 1; the IRS requires the first plan year to be at least three months.

According to Gross, most plan sponsors adopting a new safe-harbor plan use a prototype document. They have to fill out certain features they want in the adoption agreement, and it has to be signed prior to October 1. Then a written notice must be delivered to participants before October 1. Deposits of contributions need to be made in October to get that three months of coverage.

According to Friedman, any employer can take advantage of the safe-harbor plan design, not just small employers. And, if a plan sponsor has an existing plan it wants to switch to a safe-harbor design, amendments would be required for matching and non-elective contribution sections and other sections as well. Plan sponsors may wish to restate their plans entirely. Gross adds that switches to safe-harbor plan designs need to happen as of the first day of the plan year, with a 30-day prior notice to plan participants.

The October 1 deadline is not likely to be met for employers that have not already moved to adopt a new safe-harbor plan, but Gross says plan sponsors can consider it for future years. “Small business owners are overwhelmed with their business and often something like this is on their to-do list but continues to be pushed down by other priorities,” he says. “It is important to get the word out about these plans so employers can start planning in advance.”

Ubiquity’s focus is on small plans—traditionally fewer than 100 employees, and Gross says many plans it puts in place are brand new plans. He adds that many small businesses come with a tax problem after taking years to build their businesses, and a 401(k) is a primary form of retirement savings and tax relief. “There is a low-level of managing tax savings without a safe-harbor plan,” he says. “This is a key piece of our discussion with them.”

A study last year of the 2,767 small business 401(k) plans for which Employee Fiduciary provides Employee Retirement Income Security Act (ERISA) compliance services found 68% of plans use a safe-harbor 401(k) plan design to avoid annual ADP/ACP and top-heavy nondiscrimination testing. But, this is also an advantage to large plans.

According to Friedman, safe-harbor plan designs are important to a lot of employers because employers often have bad news to deliver to highly paid plan participants—namely that they cannot defer enough. The highly compensated often have their contributions curtailed and often matching contributions are forfeited due to failing nondiscrimination testing. “Safe-harbor plans allow highly paid people to make contributions they might not otherwise be able to make and to receive employer match,” he says.

“It seems as though they are becoming more popular as time goes on,” Friedman concludes. “Employers are looking to both retain employees and minimize problems with plan testing. Safe-harbor plans are very attractive to employees.”