Safe harbor 401(k)s help employers avoid expensive and burdensome IRS testing requirements.
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A safe harbor 401(k) plan is a simpler version of a traditional 401(k) retirement plan.
Employers with safe harbor 401(k)s must contribute to employee accounts through matching or non-elective contributions.
In return, employers are able to avoid burdensome IRS testing requirements.
Individuals saving for retirement can use employer-sponsored accounts to build wealth in a tax-advantaged manner. One option they have for saving is the safe harbor 401(k), a plan most likely to be used by smaller businesses.
401(k)s are popular in corporate America, but since they offer tax advantages to both employees and employers, they come with a litany of regulations. The safe harbor version of the plan allows administrators to bypass some of the rules in order to remain flexible and still reap the tax and savings benefits. Here’s how it works.
What is a safe harbor 401(k) plan?
A safe harbor 401(k) plan is a retirement plan with a special provision enabling it to avoid annual discrimination testing required of other 401(k) plans.
To qualify for this, a safe harbor 401(k) plan must supply employees with contributions that are fully vested at the time they are made. Further, employers offering these plans must adhere to certain notice requirements, which obligate them to give eligible employees information about the plan within a reasonable time frame.
Safe harbor 401(k) plans can provide many benefits for employers, including:
Reducing their compliance burden by eliminating the need to undergo annual non-discrimination testingExempting them from tests to evaluate whether they have top-heavy status, a situation where key employees own more than 60% of the assets in a retirement plan Eliminating the need to develop and follow a vesting schedule, since all employer contributions are fully vested as soon as they are madeProviding highly compensated employees with the largest deferrals possible Avoiding fees that go along with managing a traditional retirement planHarnessing the immediate vesting and matching contributions offered by these plans as a means of recruiting potential employees
Note: Highly compensated employees, or HCEs, are individuals who either earned a certain amount from their employer in the previous year — for example, over $130,000 for 2021 — or owned a stake of more than 5% in the business.
Small businesses, in particular, might want to use safe harbor 401(k) plans since they could face greater risk of failing non-discrimination testing. Further, companies with a smaller employee headcount that lose a single worker could potentially see a significant impact on contribution ratios.
“For employers, a safe harbor 401(k) plan can ensure that all employees get treated equally when it comes to participating in the company’s 401(k) plan and receiving employer matching contributions,” says Chad Rixse, director of financial planning and wealth advisor at Forefront Wealth Partners.
Since safe harbor 401(k) plans are exempt from non-discrimination testing and top-heavy testing, Rixse says, “they’re the easiest plan to administer and generally have the fewest administrative and legal headaches in the long run.”
How non-discrimination testing works
Employers that offer traditional 401(k) plans to their employees are obligated to perform annual non-discrimination tests, which are designed to ensure that HCEs do not receive an unfair amount of contributions relative to non-highly compensated employees (NHCEs).
These non-discrimination tests are called actual deferral percentage (ADP) and actual contribution percentage (ACP) tests. The ADP test looks at the elective deferrals of employees, combining it with their annual compensation to determine their actual deferral ratio (ADR). The analysis then compares the ratio of NHCEs to HCEs to see whether it is adequate.
Employers offering traditional 401(k) plans must also conduct top-heavy testing, which looks at the assets of key employees, owners, and officers of a company who met certain income or ownership requirements at any time in the year before the testing date.
Types of safe harbor 401(k) plans
There are several different kinds of safe harbor 401(k) plans, nearly all of which provide full and automatic vesting of contributions. Here is a breakdown of the different types:
1) Non-elective contributions
The employer makes a contribution for each NHCE equal to 3% of their annual compensation, whether they contribute any of their own money or not.
2) Basic matching
An employer provides a 100% match of a NHCE’s contribution, up to 3% of that employee’s annual compensation, and a 50% match for the next 2%.
3) Enhanced matching
Under this option, an employer can provide a match that is at least as generous as the ones described in the first two options, but can be up to 6% of the employee’s annual compensation.
4) Qualified automatic contribution arrangement (QACA)
Employees are automatically enrolled to contribute 3% of their compensation to the 401(k) plan, but they can opt out. The employer must choose one of the following:
Make a 3% non-elective contribution, orMatch 100% of an employee’s contributions, up to 1% of their compensation, and match 50% of their contributions after that, up to a total of 6% of their compensation
Note: QACAs deviate slightly from the other safe harbor plan designs in that employer contributions are not fully vested until the employee reaches two years of service.
Safe harbor 401(k) vs. traditional 401(k)
Safe harbor and traditional 401(k) plans differ in terms of their contribution requirements and vesting schedules. While the former has specific contribution criteria, namely making either non-elective contributions or matching employee contributions, the latter has greater flexibility.
Employers with traditional 401(k) plans have the ability to match employee contributions, make non-elective contributions on behalf of their employees, or do both.
Traditional 401(k) plans can outline specific vesting schedules, making it so that employees gain more access to employer contributions over time. Safe harbor 401(k) plans, with the exception of QACAs, provide full vesting of all employer contributions at the time they are made.
“For employees, a safe harbor guarantees that they’ll receive an employer match if they contribute to their 401(k), versus a traditional 401(k), in which they may not receive an employer match at all,” Rixse says.
Note: Both safe harbor 401(k) and traditional 401(k) plans have a 2022 contribution limit of $20,500. Employees who are at least 50 years old have the ability to contribute an additional $6,500.
The bottom line
From an employee’s perspective, one of the most attractive features of a safe harbor 401(k) is automatic and immediate vesting.
Keep in mind that if your employer offers a safe harbor 401(k), it’s obligated to meet specific notice requirements, supplying you with important details within a certain time frame. Review those documents to make sure you understand how the plan works and how you can make paycheck deferrals to maximize your savings. If you have questions, reach out to the human resources team at your company.