Welcome to our Safe Harbor 401(k) guide!
I think you’ll agree with me when I say:
Figuring out the best 401(k) for your business is REALLY hard.
There are laws. There are regulations. There are a million different ways to design a 401(k) in 2022. You might’ve heard that Safe Harbor can be a good plan design, but you’re probably wondering: what the heck is a Safe Harbor 401(k)? How do I set one up, how do I calculate the costs associated with Safe Harbor, and is it right for my business?
If you’re looking for answers to any of these questions, you’ve come to the right place.
In this article, we’ll walk you through everything you need to know to decide if a Safe Harbor 401(k) is right for your business. We’ll discuss…
- A Simple Safe Harbor 401(k) Definition
- The Primary Reason Business Owners Love Safe Harbor 401(k)s
- The Main Requirement for Safe Harbor 401(k)s
- Additional Requirements for Safe Harbor 401(k)s
- Safe Harbor 401(k) Deadlines
- Adding Profit Sharing to Your Safe Harbor 401(k)
- Is a Safe Harbor 401(k) Right for Your Business?
- Alternatives to a Safe Harbor 401(k)
Let’s get started!
A Safe Harbor 401(k) is exactly the same as a traditional 401(k), except it has a mandatory employer contribution built-in. The main advantage of Safe Harbor 401(k)s is that they are generally exempt from IRS nondiscrimination testing, which allows business owners and highly-compensated employees (HCEs) to receive much more in contributions without putting the plan into compliance trouble.
To understand why Safe Harbor plans are so awesome, we first have to understand nondiscrimination testing. What exactly is it, and what limitations does it impose on your company and your employees?
Every year, company 401(k)s are required by law to undergo nondiscrimination tests, which measure whether or not the plan favors business owners or HCEs over rank-and-file employees.
There are four tests plans must pass:
- Coverage Test: ensures that there is broad participation across both the NHCEs and the HCEs in a plan. This test looks at the percentage of NCEs who are participating relative to the percentage of HCEs participating in the plan. To pass this test, ratio must be at least 70%.
- Actual Deferral Percentage (ADP) Test: ensures HCEs aren’t deferring significantly more of their compensation than non-highly-compensated employees (NHCEs).
- Actual Contribution Percentage (ACP) Test: ensures HCEs aren’t receiving significantly more in employer contributions than NHCEs.
- Top Heavy Test: ensures the plan assets owned by individuals the IRS defines as “key employees” represent no more than 60% of the total assets in the plan.
If your plan fails any of these four tests, you’ll have to issue refunds or make special contributions to employees until the plan passes the test in question. These corrections can be costly, time-consuming, and frustrating for everyone involved.
With a Safe Harbor 401(k), you eliminate a lot of the worry. Safe Harbor 401(k)s are always exempt from the ADP and ACP tests, and are also exempt from the Top Heavy Test unless the employer makes discretionary contributions (like profit sharing) for the year in question.
With these exemptions, business owners and HCEs can defer as much as they want (up to the annual limit of $18,500) without putting the plan out of compliance.
So how exactly does a plan qualify for the Safe Harbor exemption?
There are several rules, the chief of which is the employer contribution requirement. We’ll discuss that next.
To meet the Safe Harbor provision, the plan sponsor is required to make 1 of 4 IRS-mandated contributions to its employees.
- Basic Match: a 100% employer matching contribution to all employee salary deferrals up to 3% of their compensation, and then a 50% match on the next 2% of their compensation.
- Enhanced Match: a 100% matching contribution (or more) to all employee deferrals on at least 4% (6% max) of their compensation.
- QACA Safe Harbor Match: a 100% matching contribution on the first 1% of the employee’s compensation, and then a 50% match on the next 5% of their compensation.
- Safe Harbor Non-elective Contribution: an employer contribution of at least 3% made to all eligible employees, regardless of how much they defer.
You can adopt any one of these Safe Harbor matching formulas* to meet the requirement, but which would be the most cost effective? Well, that depends on several factors:
- Compensation: how much you pay each eligible employee
- Deferral %: how much of their compensation each eligible employee defers
- Participation Rate: how many eligible employees are participating
*Note: Some employer contributions are “non-elective”, meaning the employer makes the contributions regardless of the employees’ election to participate. We have used the term matching contribution for simplicity.
To see how the different contribution formulas can work out, let’s take a look at an example.
Safe Harbor 401(k) Match Example
For a fictional hotel with 7 employees (4 of which are managers for some reason), here’s how each of the Safe Harbor match formulas would play out:
In this case, the 3% Non-Elective Contribution turns out to be the most cost-effective. Of course, these numbers can play out very differently for your business.
If you have a lot of employees who aren’t participating or deferring very much, the 3% Non-Elective Contribution can be much more costly than the matching options. To figure out which Safe Harbor arrangement is best for your business, you’ll have to run through a few different compensation and participation scenarios.
Definition of Compensation
In order for a plan to be considered Safe Harbor, compensation must be defined in the plan document in way that does not favor HCEs. Oftentimes, Safe Harbor plans define compensation as Form W-2 wages, but any definition that meets certain IRS rules will work.
Employer Contribution Vesting Schedule
Safe Harbor employer contributions are not allowed to be subject to a vesting schedule. This means the employees get to keep 100% of the contribution the minute they’re granted.
Employee Notice Requirements
Every year, employees must receive written notice of their rights and obligations under the plan. They must receive these notices within a reasonable period, generally between 30-90 days prior to the start of the plan year. These notices must also meet certain content requirements.
Mid-Year Plan Changes
Once your Safe Harbor plan is up and running, there are certain rules you must follow when making mid-year changes to your plan:
- Employees must receive notices 30-90 days before any change to the plan goes into effect.
- Employees must be allowed to change their cash or deferral election at least 30 days before the plan change goes into effect.
There are also rules around what changes can and can’t be made mid-year, so be sure to read about them here or ask your advisor.
When it comes to Safe Harbor, there are a few important deadlines to keep in mind depending on whether you’re starting a brand new 401(k) or converting an existing retirement plan into a Safe Harbor plan.
When starting a new plan:
- August 15: start plan setup (this date may vary depending on the provider you choose)
- September 1: send out Safe Harbor notices to employees
- October 1: a Safe Harbor plan must be completely setup and active (meaning that deferral begin with the first paycheck in October)
When converting an existing 401(k) to Safe Harbor:
- November 15: execute a plan amendment effective January 1 of the new plan year (contact your provider to determine their deadline for plan amendments).
- December 2: last day to send 30 day notice alerting employees of impending changes for the upcoming plan year (this is assuming your plan has a plan year that coincides with the calendar year).
Safe Harbor plans are great because they make it easier for HCEs to reach the maximum deferral limit of $18,500, but what if this isn’t enough? A business that depends on attracting and retaining HCEs might want to be more generous and help HCEs reach the maximum plan contribution limit of $55,000 ($61,000 if they’re 50 or over). With just a Safe Harbor contribution, this is impossible. That’s where profit sharing comes in.
Profit sharing contributions are the most flexible type of 401(k) employer contributions. With profit sharing, the employer contribution is entirely discretionary, and can be allocated differently for each employee (as long as your plan document allows for this type of allocation). This means the plan sponsor can target specific employees – whether HCEs or NHCEs – with major contributions that get them to maximum limit of $55,000.
Depending on how the funds are allocated, profit sharing is still subject to certain rules and tests, but when combined with a Safe Harbor 401(k), profit sharing allows business owners and key HCEs to completely max out their 401(k) contributions every year.
In general, Safe Harbor plans work best for companies for which at least one of the following is true:
- The employer wants to help HCEs reach the annual 401(k) deferral or contribution limits
- The Plan has failed nondiscrimination testing in the past and has made corrective distributions or and employer contribution to bring the plan into compliance
- The Plan has low participation among NHCEs and non-key employees
- The Employer has limited HR resources available to administer the plan
- The Employer cares about the financial wellness of its employees
Safe Harbor plans save you a lot of time, administrative hassle, and make it much easier for your key employees to max out their 401(k)s, but they can also be quite expensive. Luckily, there’s one very effective alternative.
By offering a 401(k) with a delightful employee experience, you may pass non-discrimination testing without having to resort to Safe Harbor. Doing this comes down to two strategies:
- Improve employee participation: since ADP and ACP tests look at the deferral/contribution rates of ALL eligible employees, a low participation rate can wreak havoc on your test results. Non-participating employees (usually NHCEs) have a deferral rate of 0%, which brings down their group’s average.
- Improve employee deferral rates: boosting participation rates alone isn’t enough. Getting your NHCEs to defer more of their paychecks means a higher possible ADP for the NHCE group.
Succeeding with both of these strategies can save your company a ton of money, but of course, both of these strategies are easier said than done. That’s why we wrote this short post on how to get high participation and deferral rates in your 401(k) – check it out!
Safe Harbor 401(k)s are a great way to get past all the administrative headaches and red tape imposed by IRS compliance testing, and also a great way to help your employees save for retirement.
Whether you’re starting a brand new 401(k), or looking to improve an existing plan, if you are considering a Safe Harbor Plan, you’ll want to evaluate how much it could potentially cost your business.