Safe Harbor: A Cure for Your Testing Headaches

Post On: September 21, 2021

Posted In: Business Retirement

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.)

 

  • Safe Harbor Match: With this option, the company makes a matching contribution only to those employees who choose to make salary deferral contributions. There are two types of safe harbor matching contributions:
  • Basic Safe Harbor Match: The company matches 100% of the first 3% of each employee’s contribution, plus 50% of the next 2%.
  • Enhanced Safe Harbor Match (must be at least as favorable as the basic match): A common formula is a 100% match on the first 4% of deferred compensation.
  • Safe Harbor Nonelective Contribution: With this option, the company contributes at least 3% of pay for all eligible employees, regardless of whether the employee chooses to contribute to the plan.

 

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.

  • Actual Deferral Percentage (ADP): The ADP test compares the elective deferrals (both pre-tax and Roth deferrals, but not catch-up contributions) of the HCEs and NHCEs. A failed ADP must be corrected by refunding HCE contributions and/or making additional company contributions to NHCEs.
  • Actual Contribution Percentage (ACP): The ACP test compares the matching and after-tax contributions of the HCEs and NHCEs. A failed ACP must be corrected by refunding HCE contributions and/or making additional company contributions to NHCEs.
  • Top Heavy Test: The top heavy test compares the total account balances of key employees and non-key employees. If the total key employee balance exceeds 60% of total plan assets, an additional company contribution of at least 3% of pay may be required for all non-key employees. It is important to note that a plan will lose its top heavy exemption if company contributions, in addition to the safe harbor contribution, are made for a plan year (e.g., profit sharing or discretionary matching contributions).

 

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.

 

Any opinions expressed in this forum are not the opinion or view of American Portfolios Financial Services, Inc. (APFS) or American Portfolios Advisors, Inc.(APA) and have not been reviewed by the firm for completeness or accuracy. These opinions are subject to change at any time without notice. Any comments or postings are provided for informational purposes only and do not constitute an offer or a recommendation to buy or sell securities or other financial instruments. Readers should conduct their own review and exercise judgment prior to investing. Investments are not guaranteed, involve risk and may result in a loss of principal. Past performance does not guarantee future results. Investments are not suitable for all types of investors. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purposes of avoiding penalties that may be imposed by law. Each tax payer should seek tax, legal or accounting advice from a tax professional based on his/her individual circumstances.
This material is for informational purposes only. Neither APFS nor its Representatives provide tax, legal or accounting advice. Please consult your own tax, legal or accounting professional before making any decisions. Information has been obtained from sources believed to be reliable and are subject to change without notification. The information presented is provided for informational purposes only and not to be construed as a recommendation or solicitation. Investors must make their own determination as to the appropriateness of an investment or strategy based on their specific investment objectives, financial status and risk tolerance. Past performance is not an indication of future results. Investments involve risk and the possible loss of principal.

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