The continuing popularity of
the 401(k) plan has made it the most widely used savings plan in the
country. As employers have had to shift limited resources to cover the
ever-increasing cost of other benefits, the ability for employees to
contribute to their retirement savings helped to ensure the continuation of
these plans.
There are numerous regulations that govern 401(k) plans by encouraging
broad based participation and preventing owners and highly paid employees
from receiving disproportionately greater benefits than other employees.
Plans must either satisfy a series of nondiscrimination tests each year or
be designed to satisfy certain "safe harbor" standards that are
predetermined not to be discriminatory.
While the term "safe harbor" is used in many different retirement plan
contexts, it has a very specific meaning when it comes to 401(k)
nondiscrimination tests. Before considering the specifics, it is helpful to
have a general understanding of the nondiscrimination rules.
Nondiscrimination Testing
Contributions to a 401(k) plan may include employee salary deferrals,
employer matching contributions and/or profit sharing (a/k/a nonelective)
contributions. Each year, the plan must demonstrate that contributions for
highly compensated employees (HCEs) are not disproportionately larger than
those for non-HCEs (NHCEs). HCEs are generally owners of more than 5% of the
company and any employee with compensation in the prior plan year over a
specified level ($110,000 for 2009 and 2010).
The actual deferral percentage (ADP) test and the actual contribution
percentage (ACP) test are run after the end of each plan year. The ADP test
compares the average deferral rate for the HCE group to that of the NHCE
group. In most cases, as long as the HCE average is not more than 2
percentage points greater than the NHCE average, the test passes. The ACP
test works the same way except that it analyzes employer matching
contributions. Consider this example:
Elaine owns a small company and has one employee, Mark, who earns
$150,000 per year. She has eight other employees who all earn under $100,000
per year. All employees are eligible to participate in the company's 401(k)
plan. Elaine and Mark are considered HCEs, while the other eight employees
are NHCEs. If the average deferral rate for the NHCEs is 3%, then the
average for Elaine and Mark cannot exceed 5%. If Mark defers 2% of his
compensation, Elaine could defer up to 8% of her compensation and keep their
average at or below 5%.
The top heavy determination is another test that is based on the assets
in the plan. If, on the last day of the previous year, the combined accounts
of certain company officers and owners (referred to as "key employees")
exceed 60% of the plan's total assets, the plan is considered top heavy.
Such plans are generally required to provide a minimum contribution of 3% of
compensation for all eligible non-key employees. This can come as an
unwelcome surprise for employers that had not anticipated or budgeted for
contributions to their retirement plans.
Safe Harbor Plan Eliminates Nondiscrimination Testing
The primary benefit of the safe harbor 401(k) plan is that the plan is
deemed to automatically satisfy the ADP and ACP tests. This allows HCEs to
defer up to the annual dollar limit ($16,500 for 2010) regardless of how
much or how little the NHCEs defer. In addition, plans that include only
employee salary deferrals and safe harbor contributions (described below)
are deemed to satisfy the top-heavy requirements. As a trade-off, safe
harbor plans must meet a number of requirements including minimum employer
contributions, immediate vesting and participant notices.
Safe Harbor Contributions
The employer can satisfy the contribution requirement by making either a
nonelective contribution or a matching contribution on behalf of each
eligible NHCE. The contribution can, but is not required to, be made on
behalf of HCEs as well.
Nonelective Contribution
The nonelective contribution must be at least 3% of compensation for the
plan year for each eligible employee regardless of whether or not they make
salary deferral contributions. Compensation earned prior to an employee's
eligibility date can be ignored. Plans that allocate profit sharing
contributions using a new comparability (a/k/a cross-tested) formula may
prefer the nonelective option, because the safe harbor contribution may also
be used to satisfy some of the complex testing requirements applicable to
such plans.
Matching Contribution
The matching option requires the employer to match participants' elective
deferrals at the rate of 100% of the first 3% of compensation deferred, plus
50% of the next 2% of compensation deferred (maximum match of 4%). The
employer can choose to make an enhanced match, for example, 100% of the
first 4% of compensation deferred, as long as certain guidelines are
followed.
Additional matching contributions can also be made, and they will be
exempt from the ACP test, as long as:
- They are not based on deferrals in excess of 6% of compensation, and
- If they are discretionary, they do not exceed 4% of compensation.
How the Plan is Established
Any 401(k) plan can be set up as, or amended to become, a safe harbor
plan. Generally, safe harbor provisions must be in effect for the entire
plan year, although a new plan can be established during the year as long as
it will be in effect for at least three months. This can be reduced to as
little as one month for newly formed companies with a short initial fiscal
year. Existing profit sharing plans without 401(k) provisions can be amended
mid-year to become safe harbor 401(k) plans, subject to the three-month
requirement.
The plan document must specify whether the plan will use the nonelective
or matching contributions formula, and it must address all other safe harbor
requirements described below.
Notice Requirement
A notice must be provided to eligible employees within a reasonable
period before the beginning of the plan year (or safe harbor effective
date). It will automatically be considered timely if distributed 30 to 90
days prior to the beginning of the plan year. For plans that provide for
immediate eligibility, new hires should be provided the notice on their
dates of hire.
The notice must contain the basic features of the plan, including the
safe harbor contribution to be provided and rules relating to elective
deferrals, other contributions, withdrawals, vesting, etc. Some details can
be provided by reference to the Summary Plan Description.
Safe harbor plans using the nonelective contribution can be designed as
"maybe" plans. Such a design requires that two notices be provided to
participants. The timing of the first notice is the same 30 to 90 days
described above, and it must inform participants that the employer might
make a safe harbor contribution for the coming year. The second notice is
provided 30 to 90 days before the end of the year and informs participants
whether or not the contribution will be made. In addition to satisfying this
expanded notice requirement, the "maybe" provisions must be reflected in the
plan document.
Other Rules
Safe harbor employer contributions must be fully vested and are not
available for in-service distribution prior to age 59½. An eligible
participant cannot be required to work a specified number of hours or be
employed on the last day of the plan year in order to receive the safe
harbor contribution.
Suspension of Contribution
The safe harbor matching contribution can be eliminated during the year
by adopting a formal plan amendment and providing notice to participants 30
days prior to the effective date. Contributions must be made through the end
of the 30-day period. Plans making this change lose safe harbor status for
the entire year, subjecting them not only to the ADP/ACP tests but also to
the top heavy minimum contribution requirement which could be more expensive
than the safe harbor match would have been.
As a result of the struggling economy, the IRS issued proposed
regulations in 2009 (which can be relied upon pending final regulations)
that also allow employers to suspend safe harbor nonelective contributions
if they are experiencing a substantial business hardship. This is determined
based upon whether or not:
- The employer is operating at an economic loss;
- There is substantial unemployment or underemployment in the trade of
business and in the industry concerned;
- The sales and profits of the industry concerned are depressed or
declining; and
- It is reasonable to expect that the plan would not continue unless
the contributions are reduced or suspended.
The 30-day notice and testing requirements that apply to the suspension
of safe harbor matching contributions also apply to the suspension of safe
harbor nonelective contributions.
Automatic Enrollment Safe Harbor
A modified version of the safe harbor plan is available for 401(k) plans
that contain automatic enrollment features. They provide that eligible
employees will automatically defer a specified percentage of their
compensation into the plan unless they elect not to participate, and the
default deferral rate must generally escalate each year.
The rules for so-called Qualified Automatic Contribution Arrangements (QACA)
are similar to the regular safe harbor rules, except that the QACA matching
requirement is 100% of the first 1% of compensation deferred, plus 50% of
the next 5% of compensation deferred (maximum match of 3.5%). In addition,
safe harbor contributions under the QACA must be 100% vested after two years
of service rather than the immediate vesting required of traditional safe
harbor plans. The participant notice must contain additional information
describing the automatic enrollment features.
Eligible Combined Plan
Beginning in 2010, there is a new type of safe harbor plan that includes
the combination of a 401(k) and a defined benefit formula in the same plan.
In order to qualify for this arrangement, the plan must include an automatic
enrollment 401(k) provision, a safe harbor match or nonelective contribution
as well as a minimum defined benefit. The so-called DB(k) plan is only
available for employers with fewer than 500 employees and is so new that the
IRS has not yet issued regulations describing the mechanics of how the plans
are supposed to operate.
Conclusion
A safe harbor design is an excellent way for many employers to get the
most out of their 401(k) plans. By eliminating ADP/ACP nondiscrimination
testing, all employees can contribute up to the annual deferral limit and
not be concerned about the possibility of refunds after year-end. Safe
harbor contributions may also eliminate top heavy requirements and can be
coordinated with other contribution allocations. There is much to like about
the safe harbor 401(k) plan.
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