November 7, 2011

 

Safe Harbor 401(k) feature 

(for Defined Contribution retirement plans)

 

The advantages of adding a Safe Harbor 401(k) feature are that all "highly compensated employees" may contribute the maximum statutory 401(k) limit each year (i.e. for 2012: $17,000 or $22,500 if age 50) without the risk of restrictions or refunds, while also receiving the Safe Harbor matching contribution of 3% to 4% of pay.  (Note: For 2012, the definition of "highly compensated employee" is an employee who either is a >5% owner in 2011 or 2012 or earned more than $110,000 in 2011.)

 

The tax law imposes two restrictions on 401(k) plans which can be troublesome and onerous in many cases:

  1. ADP/ACP non-discrimination testing may result in taxable refunds to "highly compensated employees" in situations in which the average 401(k) contribution rate for the group of eligible non-highly compensated employees (plus 2% in general) is lower than the average 401(k) contribution rate for the eligible highly compensated employee group.  This same test is also applied to the contribution rates for any Employer matching contributions.
  2. Top Heavy testing may result in a minimum level of Employer contributions, typically 3% of compensation to all eligible employees employed at the end of the year - if the plan is deemed to be "top heavy."  In general, if the sum of the account balances for all "key employees" is 60% or more of all account balances as of the first day of a plan year, the plan is deemed to be top heavy.  In that case, the Employer is required to make a contribution equal to the lesser of the highest benefit rate for the key employees (including 401(k) contributions) or 3% of compensation.  So, if any key employee is making a 401(k) contribution of at least 3% of pay and if the Employer is not already making a contribution of at least 3% of pay to all eligible employees, then either the key employees must reduce their contributions or the Employer must make a contribution of 3% of pay to all eligible employees employed at year-end. This top heavy test can be particularly onerous for small businesses whose plans have become top heavy solely due to normal employee turnover and who don't want to make Employer contributions in certain years.  (Note: For 2012, the definition of "key employee" includes all >5% owners, >1% owners earning >$150,000, and officers earning >$165,000.)     
The above two tests can be satisfied if a Safe Harbor 401(k) feature is added to a plan.

 

The requirements of the Safe Harbor 401(k) feature are as follows:

  • A fixed Employer contribution of 3% to 4% of pay for all eligible employees (i.e. either 3% of pay to all eligible employees on a non-matching basis or the equivalent of a 100% matching contribution on the first 4% of pay contributed by the employee), and
  • Immediate 100% vesting with respect to the Safe Harbor contribution.   

If the Safe Harbor 401(k) feature is desired, it must be added prior to the beginning of a plan year (if the plan is an existing 401(k) plan) with an initial notice to employees by December 1.  However, the Safe Harbor 401(k) feature may be changed via plan amendment prior to the start of any subsequent plan year.  Also, it is allowable to have dual eligibility provisions; for example, the plan's eligibility for making 401(k) contributions may be immediate upon employment, while requiring one year of service in order to receive the Employer's Safe Harbor contribution.