The continuing
popularity of the 401(k) plan has made it the most widely
used savings plan in the country. As employers have had to
shift limited resources to cover the ever-increasing cost of
other benefits, the ability for employees to contribute to
their retirement savings helped to ensure the continuation
of these plans.
There are numerous regulations that govern 401(k) plans
by encouraging broad based participation and preventing
owners and highly paid employees from receiving
disproportionately greater benefits than other employees.
Plans must either satisfy a series of nondiscrimination
tests each year or be designed to satisfy certain "safe
harbor" standards that are predetermined not to be
discriminatory.
While the term "safe harbor" is used in many different
retirement plan contexts, it has a very specific meaning
when it comes to 401(k) nondiscrimination tests. Before
considering the specifics, it is helpful to have a general
understanding of the nondiscrimination rules.
Nondiscrimination Testing
Contributions to a 401(k) plan may include employee
salary deferrals, employer matching contributions and/or
profit sharing (a/k/a nonelective) contributions. Each year,
the plan must demonstrate that contributions for highly
compensated employees (HCEs) are not disproportionately
larger than those for non-HCEs (NHCEs). HCEs are generally
owners of more than 5% of the company and any employee with
compensation in the prior plan year over a specified level
($110,000 for 2009 and 2010).
The actual deferral percentage (ADP) test and the actual
contribution percentage (ACP) test are run after the end of
each plan year. The ADP test compares the average deferral
rate for the HCE group to that of the NHCE group. In most
cases, as long as the HCE average is not more than 2
percentage points greater than the NHCE average, the test
passes. The ACP test works the same way except that it
analyzes employer matching contributions. Consider this
example:
Elaine owns a small company and has one employee, Mark,
who earns $150,000 per year. She has eight other employees
who all earn under $100,000 per year. All employees are
eligible to participate in the company's 401(k) plan. Elaine
and Mark are considered HCEs, while the other eight
employees are NHCEs. If the average deferral rate for the
NHCEs is 3%, then the average for Elaine and Mark cannot
exceed 5%. If Mark defers 2% of his compensation, Elaine
could defer up to 8% of her compensation and keep their
average at or below 5%.
The top heavy determination is another test that is based
on the assets in the plan. If, on the last day of the
previous year, the combined accounts of certain company
officers and owners (referred to as "key employees") exceed
60% of the plan's total assets, the plan is considered top
heavy. Such plans are generally required to provide a
minimum contribution of 3% of compensation for all eligible
non-key employees. This can come as an unwelcome surprise
for employers that had not anticipated or budgeted for
contributions to their retirement plans.
Safe Harbor Plan Eliminates
Nondiscrimination Testing
The primary benefit of the safe harbor 401(k) plan is
that the plan is deemed to automatically satisfy the ADP and
ACP tests. This allows HCEs to defer up to the annual dollar
limit ($16,500 for 2010) regardless of how much or how
little the NHCEs defer. In addition, plans that include only
employee salary deferrals and safe harbor contributions
(described below) are deemed to satisfy the top-heavy
requirements. As a trade-off, safe harbor plans must meet a
number of requirements including minimum employer
contributions, immediate vesting and participant notices.
Safe Harbor Contributions
The employer can satisfy the contribution requirement by
making either a nonelective contribution or a matching
contribution on behalf of each eligible NHCE. The
contribution can, but is not required to, be made on behalf
of HCEs as well.
Nonelective Contribution
The nonelective contribution must be at least 3% of
compensation for the plan year for each eligible employee
regardless of whether or not they make salary deferral
contributions. Compensation earned prior to an employee's
eligibility date can be ignored. Plans that allocate profit
sharing contributions using a new comparability (a/k/a
cross-tested) formula may prefer the nonelective option,
because the safe harbor contribution may also be used to
satisfy some of the complex testing requirements applicable
to such plans.
Matching Contribution
The matching option requires the employer to match
participants' elective deferrals at the rate of 100% of the
first 3% of compensation deferred, plus 50% of the next 2%
of compensation deferred (maximum match of 4%). The employer
can choose to make an enhanced match, for example, 100% of
the first 4% of compensation deferred, as long as certain
guidelines are followed.
Additional matching contributions can also be made, and
they will be exempt from the ACP test, as long as:
- They are not based on deferrals in excess of 6% of
compensation, and
- If they are discretionary, they do not exceed 4% of
compensation.
How the Plan is Established
Any 401(k) plan can be set up as, or amended to become, a
safe harbor plan. Generally, safe harbor provisions must be
in effect for the entire plan year, although a new plan can
be established during the year as long as it will be in
effect for at least three months. This can be reduced to as
little as one month for newly formed companies with a short
initial fiscal year. Existing profit sharing plans without
401(k) provisions can be amended mid-year to become safe
harbor 401(k) plans, subject to the three-month requirement.
The plan document must specify whether the plan will use
the nonelective or matching contributions formula, and it
must address all other safe harbor requirements described
below.
Notice Requirement
A notice must be provided to eligible employees within a
reasonable period before the beginning of the plan year (or
safe harbor effective date). It will automatically be
considered timely if distributed 30 to 90 days prior to the
beginning of the plan year. For plans that provide for
immediate eligibility, new hires should be provided the
notice on their dates of hire.
The notice must contain the basic features of the plan,
including the safe harbor contribution to be provided and
rules relating to elective deferrals, other contributions,
withdrawals, vesting, etc. Some details can be provided by
reference to the Summary Plan Description.
Safe harbor plans using the nonelective contribution can
be designed as "maybe" plans. Such a design requires that
two notices be provided to participants. The timing of the
first notice is the same 30 to 90 days described above, and
it must inform participants that the employer might make a
safe harbor contribution for the coming year. The second
notice is provided 30 to 90 days before the end of the year
and informs participants whether or not the contribution
will be made. In addition to satisfying this expanded notice
requirement, the "maybe" provisions must be reflected in the
plan document.
Other Rules
Safe harbor employer contributions must be fully vested
and are not available for in-service distribution prior to
age 59½. An eligible participant cannot be required to work
a specified number of hours or be employed on the last day
of the plan year in order to receive the safe harbor
contribution.
Suspension of Contribution
The safe harbor matching contribution can be eliminated
during the year by adopting a formal plan amendment and
providing notice to participants 30 days prior to the
effective date. Contributions must be made through the end
of the 30-day period. Plans making this change lose safe
harbor status for the entire year, subjecting them not only
to the ADP/ACP tests but also to the top heavy minimum
contribution requirement which could be more expensive than
the safe harbor match would have been.
As a result of the struggling economy, the IRS issued
proposed regulations in 2009 (which can be relied upon
pending final regulations) that also allow employers to
suspend safe harbor nonelective contributions if they are
experiencing a substantial business hardship. This is
determined based upon whether or not:
- The employer is operating at an economic loss;
- There is substantial unemployment or underemployment
in the trade of business and in the industry concerned;
- The sales and profits of the industry concerned are
depressed or declining; and
- It is reasonable to expect that the plan would not
continue unless the contributions are reduced or
suspended.
The 30-day notice and testing requirements that apply to
the suspension of safe harbor matching contributions also
apply to the suspension of safe harbor nonelective
contributions.
Automatic Enrollment Safe Harbor
A modified version of the safe harbor plan is available
for 401(k) plans that contain automatic enrollment features.
They provide that eligible employees will automatically
defer a specified percentage of their compensation into the
plan unless they elect not to participate, and the default
deferral rate must generally escalate each year.
The rules for so-called Qualified Automatic Contribution
Arrangements (QACA) are similar to the regular safe harbor
rules, except that the QACA matching requirement is 100% of
the first 1% of compensation deferred, plus 50% of the next
5% of compensation deferred (maximum match of 3.5%). In
addition, safe harbor contributions under the QACA must be
100% vested after two years of service rather than the
immediate vesting required of traditional safe harbor plans.
The participant notice must contain additional information
describing the automatic enrollment features.
Eligible Combined Plan
Beginning in 2010, there is a new type of safe harbor
plan that includes the combination of a 401(k) and a defined
benefit formula in the same plan. In order to qualify for
this arrangement, the plan must include an automatic
enrollment 401(k) provision, a safe harbor match or
nonelective contribution as well as a minimum defined
benefit. The so-called DB(k) plan is only available for
employers with fewer than 500 employees and is so new that
the IRS has not yet issued regulations describing the
mechanics of how the plans are supposed to operate.
Conclusion
A safe harbor design is an excellent way for many
employers to get the most out of their 401(k) plans. By
eliminating ADP/ACP nondiscrimination testing, all employees
can contribute up to the annual deferral limit and not be
concerned about the possibility of refunds after year-end.
Safe harbor contributions may also eliminate top heavy
requirements and can be coordinated with other contribution
allocations. There is much to like about the safe harbor
401(k) plan.
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