For some time the conventional wisdom has been that adopting 401k plans is too expensive and too cumbersome for the smaller business scale. Chief among the more onerous requirements had been the nondiscrimination compliance testing for contribution and compensation limits. More efficient systems and greater competition have made 401k plan adoption less expensive and cumbersome for many small employers, and, the Small Business Protection Act of 1996 provided smaller 401k plans with alternative, more simplified methods of meeting nondiscrimination requirements through the introduction of the “safe harbor 401k.”
As a result, the 401k landscape can be as friendly for a small business that is top-heavy with highly compensated employees as it is for a large corporation with a diverse mix of eligible employees. With a clear understanding of how a safe harbor 401k plan works, smaller employers can enjoy the many advantages of adopting a 401k plan, while avoiding many the arduous nondiscrimination requirements.
The Safe Harbor Advantage
Generally 401k plans are required to strictly follow certain nondiscrimination rules that determine the percentage amount of contributions made by and on behalf of more highly compensated employees. When a business meets the qualifications for adopting a safe harbor plan, it can avoid much of the compliance testing while still being able to allocate certain types and percentages of contributions to its eligible employees. The safe harbor plan requirements are less focused on the methods as they are on the outcome – that non-highly compensated and highly compensated employees receive relatively equal benefits from the plan.
While there are several options an employer can choose for designing its safe harbor plan, the primary “equalizer” employed by each is the requirement that all employer contributions –matching contributions and/or non-elective employer contributions – must be fully vested at the time they are made.
Under this option, employers can choose from two different methods of safe harbor matching contributions. First, a matching contribution can be made that is equal to 100 percent of an eligible employee’s elective deferral up to 3 percent of compensation. An additional contribution can be made on 50 percent of the deferral on the next 2 percent of compensation. The second method allows for a matching contribution equal to 100 percent of deferrals ranging from 4-6 percent of compensation.
Employers can choose to make a safe harbor non-elective contribution equal to a minimum of 3 percent of compensation for eligible employees even if they don’t make elective deferrals to the plan. The non-elective contribution is usually a percentage that may or may not be tentatively fixed depending on the employer’s objectives or ability to contribute in a given year; however, it always must be a minimum of 3 percent of eligible employee’s compensation.
A safe harbor plan may include a qualified automatic enrollment arrangement (QACA) which allows for a vesting schedule as liberal as a two year cliff instead of the immediate vesting requirement of the other two options. Under a QACA, employers can establish an automatic deferral percentage for employees who do not opt out, not to exceed 10 percent. In the first plan year, the minimum deferral percentage must be 3 percent, increasing by one percent each year until it reaches 6 percent which becomes the minimum deferral percentage. Employers can make a matching contribution of 100 percent on the first one percent of compensation plus 50 percent on the next 5 percent (3.5 percent total matching contribution) or a non-elective contribution of a minimum of 3 percent of compensation.
While these represent the primary design options for a safe harbor plan, there are many variations that can be adopted depending on an employer’s specific objectives, demographics and compensation structure. Along with the many variations comes varying levels of requirements that must be met to ensure compliance with applicable contribution and compensation limits.
The good news is that designing a safe harbor 401k plan doesn’t have to be complicated or expensive; and the upside for a properly designed plan will almost always exceed any costs. However, a poorly conceived plan, or one that isn’t properly monitored and updated for compliance, can wreak havoc on an employer. Working with an experienced safe harbor plan design specialist can ensure your plan is optimally designed and implemented to fit your needs, from maximizing certain employees or to just providing retirement options to your work force.