A 401(k) plan makes it easier for your employees to save for retirement. To ensure everyone is benefitted from the plan, the IRS has established nondiscrimination tests to measure whether a 401(k) plan unduly favors highly compensated employees.
What are nondiscrimination tests and how do they affect your 401(k) plan?
The nondiscrimination tests provide highly compensated and non-highly compensated (NHCEs) employees with equal opportunities to save for the future. These tests ensure everything stays fair. It also looks over how much a company contributes to the employee accounts and the asset percentage belonging to the highly compensated employees (HCEs).
To keep a check on whether the 401(k) plan is benefitting the owner and the employee, the nondiscrimination tests are divided into three main types:
- The Actual Deferral Percentage (ADP) Test: It is created to compare the salary deferrals of NHCEs with the HCEs. It shows how much the employees’ salary goes towards their benefit plan.
- The Actual Contribution Percentage (ACP) Test: Almost the same as the ADP test, the ACP test compares the employer’s contribution to HCEs with everyone else.
- Top-Heavy Test: It measures the key employees’ asset values in their 401(k) accounts compared to the assets held in their 401(k) plan.
If there are any failures in these tests, you will have to face the consequences. This is where a safe harbor 401(k) can help! With a safe harbor, you are secured against the uncertainties of these annual tests.
What is a safe harbor 401(k) plan?
A safe harbor plan is a part of the 401(k) plan designed to satisfy the nondiscrimination tests. It intends to provide all 401(k) account holders with an employer contribution. In exchange for this, the IRS offers employers a safe harbor, a pass from any nondiscrimination tests, and they do not have to face any failure consequences.
How does a safe harbor 401(k) work?
Companies with the regular 401(k) plan must pass the nondiscrimination test every year. But the ones that follow the safe harbor structure already ensure they comply with the governmental requirements. Moreover, the ADP test cannot cap out the highly compensated employers.
Apart from the owners, even the employees can benefit. With a safe harbor 401(k) plan, everyone can contribute upto $20,500 in 2022. Individuals above 50 can contribute an additional $6,500 in catch-up contributions.
In the traditional safe harbor 401(k) plan, the employer has to make contributions and vest them immediately. These contributions have three forms.
The first two forms are called matching – here, the employees must defer their funds to receive contributions. While in the third form, a company has to contribute even if the employees do not defer their income.
- Basic Matching: Here, the company has to match 100% of all employee 401(k) contributions, up to 3% of their compensation, and a 50% match of the next 2% of their compensation.
- Enhanced Matching: In this form, the company has to match at least 100% of all employee 401(k) contributions, up to 4% of their compensation. The compensation cannot exceed over 6%.
- Non-elective Contribution: The company has to contribute 3% of each employee’s compensation. It does not matter whether the employee contributes.
The safe harbor plan provides flexibility. It can be inclined to any type of retirement or 401(k) plan. However, the plan participants should be educated on this and given written notice.
Types of safe harbor 401(k) plan
You can set a safe harbor 401(k) plan either with or without a match. Here are all the 401(k) safe harbor match and contribution options available:
- Basic Safe Harbor: Here, the plan will match 100% of contributions up to 3% of an employee’s compensation and then 50% of an employee’s additional contributions, up to 5% of pay. This plan is also known as the elective safe harbor.
- Non-elective Safe Harbor: Employers have to give 3% of retirement contributions to every employee, regardless of whether the employee has chosen to participate.
- Enhanced Safe Harbor: Yet another type of elective plan, this plan provides a 100% match of up to 4% of an employee’s compensation.
- QACA Safe Harbor: QACA, Qualified Automatic Contribution Arrangement, this plan sets aside 3% of an employee’s compensation in the 401(k) plan. Moreover, until the deferral rate reaches 6%, there’s an auto-increase of 1% compensation per year. Companies have to match 100% of the first 1% of contributions and 50% deferrals between 1% to 6% of compensation.
How can you set up a safe harbor 401(k)?
Financial professionals in your area are the best to approach if you want suggestions on retirement plan providers to help you set up your 401(k) plan.
Employee advantages of a safe harbor 401(k)
Alongside companies, even employees can benefit from safe harbor 401(k). Apart from employers contributing to their retirement funds, other benefits include immediate vesting and tax deductions.
In the traditional 401(k) plan, the employee has to work for a certain fixed amount of time before accessing the funds. But with employer contributions to the safe harbor 401(k) plan, vesting is scheduled almost immediately. This means employees can keep whatever is deposited into the plan.
Moreover, as an employer, you can use this as a competitive advantage to gain and retain some of the best talents in your company.
Is a safe harbor 401(k) plan right for my company?
Safe harbor 401(k) is a great option for companies with steady revenue. But if you think your company can face trouble generating consistent matching funds, you might want to explore other 401(k) plan options.
Moreover, a safe harbor plan is a good option if your company does any of the following:
- Matched employee contributions
- Failed either the ADP, ACP, or Top-Heavy tests
- Low participation of NHCEs or non-key employees
- Worried about the nondiscrimination tests
However, there are certain pros and cons. The biggest downside is increased payroll by 3% if all employees participate. But several employers think the pros outweigh the cons. Safe harbor 401(k) will lead to tax savings, happier employees, and no failures in nondiscrimination tests.
A safe harbor 401(k) plan has great benefits for employers and employees, but before deciding, consult a financial professional to understand whether this plan is the right fit for your company.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning company based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last ten years has turned his focus to self-directed ira accounts and alternative investments. If you need help and guidance with traditional or alternative investments, call him today (866) 639-0066.