One
of the more frustrating aspects for the small business maintaining a 401(k)
plan is satisfying the special nondiscrimination requirements. The tests
require adequate participation by "non-highly compensated employees" (NHCEs)
in order for the "highly compensated employees" (HCEs) to maximize their own
salary deferrals. Failure to satisfy the tests requires a correction which
often means the painful process of returning salary deferrals to the HCEs.
For a number of years, employers have had the option to simplify this
process and avoid the tests altogether by providing a "safe harbor"
contribution for NHCEs. Beginning in 2008, plans that use automatic
enrollment have a new, somewhat more flexible, safe harbor option.
To help those employers still struggling with the nondiscrimination tests
or for those who have chosen a safe harbor design and would like to consider
the new option, this article will review and contrast the various safe
harbor options that are now available, as well as discuss automatic
enrollment as a method of solving testing problems.
Testing Requirements
Absent a safe harbor contribution, a 401(k) plan must satisfy the ADP
test each plan year. This requires calculating each eligible participant’s
deferral percentage and comparing the average percentage of the HCEs to the
average percentage of the NHCEs. HCEs are employees who:
- Owned more than 5% of the employer in the current or previous year, or
- Earned more than a specified limit in the previous year ($100,000 for
2007).
Employer matching contributions and after-tax employee contributions must
satisfy a similar ACP test. Failure to satisfy either test requires either
returning excess deferrals or contributions to the HCEs (within 2½ months of
the end of the plan year) or making additional employer contributions
(within 12 months after the end of the plan year).
In addition, a "top heavy plan" (more than 60% of the benefits under the
plan belong to "key employees") must satisfy special contribution
requirements. Even if the sponsor makes matching contributions, additional
top heavy contributions may have to be made to ensure that all non-key
participants receive the required contribution which, in most cases, is 3%
of compensation.
Traditional Safe Harbor Options
If a qualifying safe harbor contribution is made to a 401(k) plan, the
plan is deemed to satisfy the ADP test. This means the HCEs may make the
maximum allowable deferral of compensation ($15,500 in 2008 plus $5,000
catch up contribution if age 50 or over).
In most cases the ACP test is also avoided and the plan is deemed to have
satisfied the top heavy requirements. The safe harbor contributions must be
100% vested and are not available for hardship or other in-service
withdrawals before age 59½.
The employer must adopt a safe harbor provision prior to the beginning of
the plan year. Also, participants must be notified of the employer’s intent
to make safe harbor contributions within 30 to 90 days prior to the
beginning of the plan year. There are several types of employer
contributions that can satisfy the safe harbor.
Nonelective Contributions
One option is to make a 3% nonelective contribution for all NHCEs
eligible to participate in the plan. Contributions must be made for all
eligible participants regardless of whether the participant has worked 1,000
hours during the year or was employed on the last day of the plan year.
Matching Contributions
As an alternative, the employer can make a basic matching contribution
for all eligible NHCEs who choose to make salary deferrals at the following
rate: 100% of the first 3% of compensation deferred, plus 50% of the next 2%
deferred. The sponsor may contribute an "enhanced" match equal to at least
the amount of the basic match (e.g., 100% of the first 4% deferred). Under
the enhanced match, the contribution rate cannot increase as an employee’s
deferral rate increases, and the contribution rate for HCEs cannot exceed
the contribution rate for the NHCEs.
Qualified Automatic Contribution Arrangement
For plan years beginning in 2008, the Pension Protection Act established
a "qualified automatic contribution arrangement (QACA) that acts as an
additional type of safe harbor design (meaning the plan automatically
satisfies the ADP and ACP tests as well as top heavy requirements).
Under a QACA, an eligible employee automatically has a specified
percentage of compensation withheld unless he makes an affirmative election
either not to participate or to change the amount of the default election. A
QACA can allow automatic deferrals of up to 10% of compensation but, as a
minimum, the plan must require automatic deferral of 3% the first year, 4%
the second, 5% the third and 6% thereafter.
The employer can make either:
- A 3% nonelective contribution for each NHCE, or
- A match contribution of 100% of the first 1% deferred and 50% of the
next 5% deferred.
Unlike the traditional safe harbor design, contributions do not have to
be fully vested until an individual has earned two years of service.
A QACA is similar to a traditional safe harbor design in several
respects. Contributions are required to be subject to withdrawal
restrictions and cannot be restricted to those meeting an eligibility
requirement (1,000 hours of service or employment on the last day of the
plan year). Also the same rules apply concerning the timing of the plan
amendment and annual notice to participants about the safe harbor
contributions.
There is also an annual required notice about the automatic enrollment
feature that must notify participants of:
- The level of elective contributions under the default;
- The employee’s right to elect out of or change the amount of the
deferral election; and
- How contributions will be invested in the absence of an employee
investment election.
Choosing a Safe Harbor Option for the First Time
A 401(k) plan sponsor struggling with testing issues should seriously
consider one of the safe harbor designs. An employer reluctant to make the
required contributions should also consider automatic enrollment (without a
safe harbor contribution) as a method to increase participation and thereby
improve test results.
Automatic Enrollment
Based on evidence that automatic enrollment can increase participation
significantly, the Pension Protection Act included several automatic
enrollment options to encourage this practice. The concept is simple:
automatic enrollment brings in those who fail to participate simply because
of inertia. This is likely to have the biggest impact on the young, a group
that benefits the most from compounding returns over an accumulation period
of 30 years or more.
An "eligible automatic contribution arrangement" (EACA), which is also
new for 2008, can be an effective approach that does not require a safe
harbor contribution. With an EACA, the sponsor sets the default deferral
percentage at any level and does not have to increase it each year as under
a QACA.
The program requires the use of a qualified default investment
arrangement, and the sponsor has the option to allow new enrollees the
option to withdraw contributions within 90 days of enrollment. The EACA has
one other advantage: the 2½ month correction period under the ADP and ACP
tests is extended to 6 months.
Electing a Safe Harbor Design
Other employers will want to consider adopting either a traditional safe
harbor or QACA. It’s important to understand that each of these options
provides the sponsor design flexibility. In addition to the safe harbor
contribution, the sponsor can make an additional discretionary matching
contribution and still avoid the ACP test as long as certain requirements
are met.
It can also be meaningful that the safe harbor options, in most cases,
eliminate the complication of any top heavy problems. However, if the plan
uses a matching contribution to satisfy the safe harbor and any other
employer contributions are made, the plan must still demonstrate compliance
with the top heavy rules.
When selecting one of the options there are several clear differences
between the traditional safe harbor and the new QACA. First, the QACA does
not require immediate full vesting—two years of service can be required.
Second, the maximum required matching contribution is effectively 3.5% of
compensation and not 4%. This can reduce the employer’s contribution cost
somewhat, but this advantage may be offset by a higher rate of participation
under a plan that has automatic enrollment.
Plans Currently Using a Safe Harbor Design
If an employer is currently using a traditional safe harbor design with
the 3% nonelective contribution, a QACA with a nonelective contribution is a
good alternative. The contribution cost is the same, but added participation
means more retirement security. Some employers will appreciate the ability
to have a vesting provision, although changing the vesting provision does
complicate administration.
As discussed above, a QACA with a matching contribution may be more or
less expensive than the current safe harbor, depending upon the
circumstances. If the safe harbor plan currently has a high level of
participation or if it is not expected that automatic enrollment will have
much of an impact on participation levels, then the QACA safe harbor
contribution will cost less than the traditional approach. Even if the cost
is a bit more, due to increased participation, an employer motivated by the
other benefits of automatic enrollment may still choose to switch.
Finally, note that an employer that appreciates the benefits of automatic
enrollment but is satisfied with the current safe harbor can also choose to
add an automatic enrollment feature and maintain the current safe harbor
design.
Conclusion
With the introduction of new options, it is a good time for a 401(k) plan
sponsor to review current plan design. Testing problems can now be addressed
with automatic enrollment either with or without a safe harbor contribution.
Some employers concerned about the retirement preparedness of employees may
choose to add automatic enrollment, even if the plan doesn’t have testing
problems.
Current safe harbor designs should also be reviewed to determine whether
it’s appropriate to switch to the QACA approach, either as a way to save on
the cost of the required contribution, the ability to have vesting or simply
out of concern for the well-being of the participants.
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