Post On: September 21, 2021
A crucial requirement for 401(k) plans is that the plan must be designed so it does not unfairly favor highly compensated employees (HCES) or key employees (such as owners) over others (NHCES). For many profitable businesses, however, the desire for owners to maximize funding is essential to personal tax planning.
To satisfy this requirement, the IRS requires that plans pass certain nondiscrimination tests each plan year. These tests analyze the ratio at which HCEs and key employees benefit from the plan in comparison to the rest of the employees. Failed tests can result in costly corrections, such as taxable refunds to HCEs and key employees or the need for additional company contributions. Luckily for plan sponsors, there is a plan design option, known as a “safe harbor,” that allows companies to avoid most of these nondiscrimination issues.
To be considered safe harbor and take advantage of the benefits afforded to safe harbor plans, there are several requirements that must be satisfied. Below, we will take a look at the key characteristics of a safe harbor plan.
The plan must include one of the following types of contributions, provided to all eligible employees each plan year. (Please note that additional options, not covered here, are provided for plans that include certain automatic enrollment features.)
Unlike company profit sharing or discretionary match contributions, safe harbor contributions must be 100% vested immediately. In addition, the contribution must be provided to all eligible employees, even those who did not work a minimum number of hours during the plan year or who are not employed on the last day of the plan year. This is the “price” necessary to ensure any deferral for company owners and HCEs.
In most cases, an annual safe harbor notice must be distributed to plan participants within a reasonable period before the start of each plan year. This is generally considered to be at least 30 days (and no more than 90 days) before the beginning of each plan year. For new participants, the notice should be provided no more than 90 days before the employee becomes eligible and no later than the employee’s date of eligibility. The safe harbor notice informs eligible employees of certain plan features, including the type of safe harbor contribution provided under the plan.
If all safe harbor requirements have been satisfied for a plan year, the following nondiscrimination tests can be avoided.
So, how do you know if a safe harbor plan is a good fit for your company? As discussed above, the primary benefit of a safe harbor plan is automatic passage of certain annual nondiscrimination tests. If your plan typically fails these tests, resulting in refunds or reduced contributions to HCEs and key employees, your company may benefit from a safe harbor feature. Predictable annual contributions also provide a great incentive for employees to save for their retirement. However, if you do not currently offer an annual match or profit sharing contribution to your employees, a safe harbor formula may significantly impact your company’s budget. Except for a few limited exceptions, safe harbor contributions cannot be removed during the plan year, so it’s important that a company is able to fund these required contributions. As with all things qualified plan related, the key is working with an experienced service provider. Contact the retirement plan experts at Ambassador Advisors who can design a plan to suit your company’s needs.
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