Is a Safe Harbor Plan the Right Move?
This Alternate Approach Can Save Headaches, But At a Price
On an annual basis plan administrators have to deal with the stress of the dreaded top-heavy testing. They worry whether highly compensated employees (“HCEs”) will have “excess” salary deferrals returned to them due to the plan failing the actual deferral percentage/actual contribution percentage (“ADP/ACP”) discrimination tests? To the rescue come the “safe harbor” rules that nearly always eliminate the need to worry about passing these tests, but be aware that these rules have risks also.
What Are the Test Formulas?
The current threshold for HCE status is an annual salary of $120,000, or at least 5% company ownership.
The first step is to calculate your HCEs’ average deferral rates, including employees eligible to participate in the plan but, who choose not to (ADP test). For example, if you have only four HCEs, and one deferred 7% and the others 8%, the average is 7.75%. Using the same calculation method, suppose that your non-highly compensated employees’ (“NHCEs”) average deferral rate is 6.5%.
In the above scenario, you’d pass the test because, when the NHCE average deferral rate is between 2% and 8% (as is typical), the HCEs’ ADP can exceed the NHCEs’ by up to two percentage points. That is, the NHCEs’ average deferral could have been as low as 5.75%, and you’d still pass. (Different formulas kick in when the NHCEs’ average deferral rate is below 2% or above 8%.)
The ACP test is similar, but also includes employer matching contributions and after-tax employee deferrals.
What If You Fail?
For plans that consistently fail those tests by a wide margin, a safe harbor plan design could be the solution. A safe harbor plan design provides two formula categories to choose from to avoid ADP/ACP testing, as well as top-heavy testing:
- Minimum matching contribution formulas. This requires plans to either:
- Match 100% of the first 3% of deferred compensation and 50% on deferrals between 3% and 5% (which means the maximum you’d contribute is 4% of employee compensation), or
- Match 100% on the first 4% deferred.
- Nonelective contribution rate. The company must contribute 3% of the eligible employee’s compensation, regardless of how much or little NHCEs save on their own.
Be aware that all safe harbor contribution amounts must vest immediately with the employee.
How About a QACA?
Another type of safe harbor plan is referred to as a qualified automatic contribution plan (“QACA”). Under this plan, (1) employees are auto-enrolled into the plan, and (2) a qualified default investment option such as a target date fund is selected. The minimum initial deferral rate must be 3% and annual deferral rate increases of at least 1%, until the deferral rate reaches at least 6%, but no more than 10%.
Additionally, the plan must match 100% of deferrals on the first 1% deferred, and at least 50% on incremental deferrals up to 6%. (The net result is a maximum required match of 3.5%.) A two-year cliff vesting formula is permissible.
Getting the Plan in Place
If you want to establish a safe harbor plan, you must do so by October 1 for calendar year plans. For an existing 401(k) plan, you have until January 1 to start as a safe harbor plan.
Notification of intent to be a safe harbor plan for the coming year must be provided to the participants at least 30 days prior to the new plan year. If you currently have a 401(k) plan, check your plan documents to ensure you can amend them to add a safe harbor plan.
How to Decide?
Meet with your benefits advisor to discuss the pros, cons and applicable documentation. He or she can review the ADP/ACP discrimination tests with you, as well as determine whether a safe harbor plan would work for your organization. The safe harbor route is the path of least resistance, but it can also be the more expensive one.
How Costly Is It?
How much would a safe harbor plan “cost” you? The answer depends on:
- How elaborate and aggressive a 401(k) promotion plan you’d need to convince enough nonhighly compensated employees to participate and tilt the scales, and
- How close to the minimum safe harbor matching and nondiscretionary contribution formulas you’d need to get to clear the tests.
Once you have the answers to the points above, the next step would be to weigh the dollars at stake against your goals behind sponsoring a 401(k) plan in the first place. In the end, spending a bit more by establishing a safe harbor plan could be worth the (potentially extra) investment in helping employees save for their future.
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