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Safe Harbor: A Cure For Your Testing Headaches

A crucial requirement for 401(k) plans is that the plan must be designed so it does not unfairly favor highly compensated employees (HCEs) or key employees (such as owners) over non-highly compensated employees (NHCEs). To satisfy this requirement, the IRS requires that plans pass certain nondiscrimination tests each plan year. These tests analyze the rate at which HCE and key employees benefit from the plan in comparison to NHCEs. Failed tests can result in costly corrections, such as refunds to HCEs and key employees or additional company contributions. Luckily for plan sponsors, there is a plan design option – a safe harbor feature, that allows companies to avoid most of these nondiscrimination tests.

To be considered safe harbor and take advantage of the benefits afforded to safe harbor plans, there are several requirements that must be satisfied. Below we will take a look at the key characteristics of a safe harbor plan.

The plan must include one of the following types of contributions. The chosen formula is written in the plan document, and with the exception of HCEs, must be provided to all eligible employees each plan year. Please note that additional options, not covered here, are provided for plans that include certain automatic enrollment features.

  • Safe Harbor Match: With this option, the company makes a matching contribution only to those employees who choose to make salary deferral contributions. There are two types of safe harbor matching contributions:
    • Basic Safe Harbor Match: The company matches 100% of the first 3% of each employee’s contribution, plus 50% of the next 2%.
    • Enhanced Safe Harbor Match: Must be at least as favorable as the basic match. A common formula is a 100% match on the first 4% of deferred compensation.
  • Safe Harbor Nonelective: With this option, the company contributes at least 3% of pay for all eligible employees, regardless of whether the employee chooses to contribute to the plan.

Unlike company profit sharing or discretionary match contributions, safe harbor contributions must be 100% vested immediately. In addition, the contribution must be provided to all eligible employees, even those who did not work a minimum number of hours during the plan year or who are not employed on the last day of the plan year.

In most cases, an annual safe harbor notice must be distributed to plan participants within a reasonable period before the start of each plan year. This is generally considered to be at least 30 days (and no more than 90 days) before the beginning of each plan year. For new participants, the notice should be provided no more than 90 days before the employee becomes eligible and no later than the employee’s date of eligibility. The safe harbor notice informs eligible employees of certain plan features, including the type of safe harbor contribution provided under the plan.

If all safe harbor requirements have been satisfied for a plan year, the following nondiscrimination tests can be avoided:

  • Actual Deferral Percentage (ADP): The ADP test compares the elective deferrals (both pre-tax and Roth deferrals, but not catch-up contributions) of the HCEs and NHCEs. A failed ADP must be corrected by refunding HCE contributions and/or making additional company contributions to NHCEs.
  • Actual Contribution Percentage (ACP): The ACP test compares the matching and after-tax contributions of the HCEs and NHCEs. A failed ACP must be corrected by refunding HCE contributions and/or making additional company contributions to NHCEs.
  • Top Heavy Test: The top heavy test compares the total account balances of key employees and non-key employees. If the total key employee balance exceeds 60% of total plan assets, an additional company contribution of at least 3% of pay may be required for all non-key employees. It is important to note that a plan will lose its top heavy exemption if company contributions, in addition to the safe harbor contribution, are made for a plan year (e.g., profit sharing or discretionary matching contributions).

So, how do you know if a safe harbor plan is a good fit for your company? As discussed above, the primary benefit of a safe harbor plan is automatic passage of certain annual nondiscrimination tests. If your plan typically fails these tests, resulting in refunds or reduced contributions to HCEs and key employees, your company may benefit from a safe harbor feature. Predictable annual contributions also provide a great incentive for employees to save for their retirement. However, if you do not currently offer an annual match or profit sharing contribution to your employees, a safe harbor formula may significantly impact your company’s budget. Except for a few limited exceptions, safe harbor contributions cannot be removed during the plan year, so it’s important that a company is able to fund these required contributions. As with all things qualified plan related, the key is working with an experienced service provider who can design a plan to suit your company’s needs!

Missing Participants: Ready or Not, Here I Come!

Most plan sponsors can relate to the trials and tribulations of having missing participants in their retirement plan. At times, it may feel like you are on the losing end of an intense game of hide-and-seek. Your opponents, the missing participants, may not have intended to pick the best hiding spots, but in many cases, they have surely succeeded. Now you are tasked with tracking them down and upping your game to avoid this scenario in the future.

So, what are missing participants, exactly? Missing participants are former employees who left an account balance in a retirement plan and did not keep their contact information up to date. In addition, they may no longer actively manage their accounts. There are a few factors that have led to an increase in the number of missing participants in retirement plans over the years. Unlike the generations of our parents and/or grandparents, employees do not typically work their entire career with one firm anymore. Another contributing factor is the mobilization of the workforce. The ability to work remotely has mobilized employees even more these days. Some have chosen to relocate across the country while others find themselves living in a new locale every few months. Many of us can relate to this, especially over the past 18 months. With these two factors alone, it can be difficult to keep track of plan participants once they leave your firm.

It is important to develop procedures to ensure contact information is up to date and to illustrate the proactive measures employed in this effort. Whatever steps you implement, you should relay to employees and participants why keeping these details current is important and how it can affect them. Ask any employee if they would be okay with losing track of their retirement account – the answer would probably be a resounding no. A few ideas based on the Department of Labor’s (DOL’s) Best Practices are included below.

  • Annual Review: Have plan participants verify their contact information on file at least annually. This includes addresses, phone numbers, and email addresses. You can also include a review of beneficiaries at this time. Keep in mind this does not only include current employees but terminated or retired participants as well. Also consider making the review part of your company’s exit interview.
  • Mailings: When completing a mailing, provide a form where recipients can update their contact information.
  • Returned Mail: Initiate searches for participants as soon as mail has been returned as undeliverable. This includes mail marked as “return to sender,” “wrong address,” “addressee unknown,” or otherwise.
  • System Log In: If participants regularly log into a system, set a reminder or pop-up directing users to verify their contact information.

Unfortunately, even with the best of plans in place, plan sponsors may still have participants who go missing. So, not only do you need to incorporate procedures for ensuring contact information is up-to-date, but you also need to document procedures for locating participants once they go missing. The DOL provides a list of search methods that should be used to locate missing participants. Some of these methods are included below.

  • Send a notice using certified mail through USPS or a private delivery service with similar tracking features.
  • Check the records of the employer or any related plans of the employer.
  • Send an inquiry to the designated beneficiary or emergency contact of the missing participant.
  • Use free electronic search tools or public record databases.

At some point, most plan sponsors will find themselves with participants who have gone missing. It’s important to remember plan sponsors have a fiduciary responsibility to follow the terms of the plan document and ensure participants are paid out timely. Having a well-documented, organized process which addresses missing participants, along with proof the process is followed, will prove worthwhile.

More information regarding the Department of Labor’s Best Practices can be located on their website.

https://www.dol.gov/agencies/ebsa/employers-and-advisers/plan-administration-and-compliance/retirement/missing-participants-guidance/best-practices-for-pension-plans

Markets in Review

U.S. stocks continued to rally during the second quarter with the S&P 500 Index returning 8.55% and ending the quarter at an all-time high. The equity markets benefited from strong economic growth, low interest rates, increasing company profits and substantial progress on the vaccine front in the developed markets.

In a reversal of the trend last quarter, the equity markets rotated back to favoring growth over value stocks. The Russell 1000 Growth Index returned 11.9%, while the Russell 1000 Value Index returned 5.2% during the quarter.

Another trend reversal occurred with large caps outperforming small caps during the quarter. However, small cap stocks performed so well during the first quarter that they are still outperforming large caps on a year-to-date basis.

All S&P 500 sectors were in positive territory during the quarter with the exception of utilities, with real estate and technology leading the way returning 13.1% and 11.6%, respectively.

Non U.S. equity markets also posted positive returns during the quarter with developed markets (as measured by the MSCI All Country World Index ex US) leading emerging markets (as measured by the MSCI Emerging Markets Index). Conditions in Europe continued to improve as many pandemic-related restrictions were lifted.

The U.S. Treasury yield curve flattened slightly during the quarter as longer-term rates continued to fall. All major fixed income sectors experienced positive returns during the quarter as bond yields fell by over 25 bps. The 10-year Treasury fell from 1.74% to 1.45% during the quarter, resulting in a positive return of the Barclays US Aggregate Bond Index of 1.83%.

U.S. economic growth in the second quarter of 2021 was supported by accommodative fiscal and monetary policies, pent-up consumer demand leading to strong corporate earnings, and a rollback of many of the pandemic-related restrictions. Second quarter GDP expanded at an annual rate of approximately 6.5% based on the first advanced estimate.

The economy added 1.7 million jobs during the quarter, however, despite the latest employment growth, the economy is still approximately 7 million jobs short of pre-COVID levels. Notable job gains occurred in leisure and hospitality, public and private education, professional and business services, and retail trade. The unemployment rate continued to fall and equaled 5.9% in June. Reported job openings have been rising and are approximately equal to the number of unemployed.

Inflation received much attention during the second quarter as headline inflation, measured by the Consumer Price Index (CPI-U), more than doubled to 5.4%, up from 2.6% the previous quarter, the biggest spike in inflation in more than a decade. Many businesses cited increased prices from supply chain disruptions, higher raw materials costs, and shipping constraints. Areas of the economy experiencing pent-up demand saw double digit price increases, such as transportation, energy prices and used vehicles, which were major contributions to the significant jump in inflation figures for the quarter.

Back to School: Financial Literacy Tips

As your high school and college-age kids head back to school, equip them with the tools they need to take charge of their financial lives! This starts with getting your kids to understand how to manage their finances such as the basics of budgeting, making saving a priority, understanding debt and their credit score, learning about investments and taxes. Watch with the links below:

Connecting The Dots to Your Financial Future (Part 1): Budgeting & Saving, Understanding Debt & Credit

Connecting The Dots to Your Financial Future (Part 2): Creating Healthy Financial Habits, Investing

A Definitive Guide for Education Planning: Understanding Student Loans, Tips to Maximize Student Aid

Visit our YouTube Channel for more educational content.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

Tax Benefits of Home Ownership

The tax code provides several benefits for people who own their homes. In tax lingo, your principal residence is the place where you legally reside. It’s typically the place where you spend most of your time, but several other factors are also relevant in determining your principal residence. Many of the tax benefits associated with home ownership apply mainly to your principal residence — different rules apply to second homes and investment properties. Here’s what you need to know to make owning a home really pay off at tax time.

Deducting mortgage interest

One of the most important tax benefits that comes with owning a home is the fact that you may be able to deduct any mortgage interest that you pay. If you itemize deductions on Schedule A of your federal income tax return, you can generally deduct the interest that you pay on debt resulting from a loan used to buy, build, or improve your home, provided that the loan is secured by your home. In tax terms, this is referred to as “home acquisition debt.” You’re able to deduct home acquisition debt on a second home as well as your main home (note, however, that when it comes to second homes, special rules apply if you rent the home out for part of the year).

For mortgage debt incurred prior to December 16, 2017, up to $1 million of home acquisition debt ($500,000 if you’re married and file separately) qualifies for the interest deduction. If your mortgage loan exceeds $1 million, some of the interest that you pay on the loan may not be deductible.

For mortgage debt incurred after December 15, 2017, up to $750,000 of home acquisition debt ($375,000 if you’re married and file separately) qualifies for the interest deduction. If your mortgage loan exceeds $750,000, some of the interest that you pay on the loan may not be deductible.

A deduction is no longer allowed for interest on home equity indebtedness. Home equity used to substantially improve your home is not treated as home equity indebtedness and can still qualify for the interest deduction. That means the project must add to your home’s value, prolong its useful life or adapt it for new uses.

For more information, see IRS Publication 936.

Mortgage insurance

You can generally treat amounts you paid during 2021 for qualified mortgage insurance as home mortgage interest, provided that the insurance was associated with home acquisition debt and was being paid on an insurance contract issued after 2006. Qualified mortgage insurance is mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing Administration, the Rural Housing Service, and qualified private mortgage insurance (PMI) providers. The deduction is phased out, though, if your adjusted gross income was more than $100,000 ($50,000 if married filing separately).

Starting in 2022, amounts paid for qualified mortgage insurance are generally not deductible.

Deducting real estate property taxes

If you itemize deductions on Schedule A, you can also generally deduct real estate taxes that you’ve paid on your property in the year that they’re paid to the taxing authority. However, for 2018 to 2025, individuals are able to claim an itemized deduction of up to only $10,000 ($5,000 for married filing separately) for state and local property taxes (SALT) and state and local income taxes (or sales taxes in lieu of income taxes). Previously, there were no dollar limits. However, see BFSG’s recent blog post on California’s Assembly Bill 150 that provides a SALT cap workaround.

If you pay your real estate taxes through an escrow account, you can only deduct the real estate taxes actually paid by your lender from the escrow account during the year. Only the legal property owner can deduct real estate taxes. You cannot deduct homeowner association assessments since they are not imposed by a state or local government.

AMT considerations

If you’re subject to the alternative minimum tax (AMT) in a given year, your ability to deduct real estate taxes may be limited. That’s because, under the AMT calculation, no deduction is allowed for state and local taxes, including real estate tax.

Deducting points and closing costs

Buying a home is confusing enough without wondering how to handle the settlement charges at tax time. When you take out a loan to buy a home, or when you refinance an existing loan on your home, you’ll probably be charged closing costs. These may include points, as well as attorney’s fees, recording fees, title search fees, appraisal fees, and loan or document preparation and processing fees. You’ll need to know whether you can deduct these fees (in part or in full) on your federal income tax return, or whether they’re simply added to the cost basis of your home.

Before we get to that, let’s define one term. Points are certain charges paid when you obtain a home mortgage. They are sometimes called loan origination fees. One point typically equals one percent of the loan amount borrowed. When you buy your main home, you may be able to deduct points in full in the year that you pay them if you itemize deductions and meet certain requirements. You may even be able to deduct points that the seller pays for you. More information about these requirements is available in IRS Publication 936.

Refinanced loans are treated differently. Generally, points that you pay on a refinanced loan are not deductible in full in the year that you pay them. Instead, they’re deducted ratably over the life of the loan. In other words, you can deduct a certain portion of the points each year. If the loan is used to make improvements to your principal residence, however, you may be able to deduct the points in full in the year paid.

What about other settlement fees and closing costs? Generally, you cannot deduct these costs on your tax return. Instead, you must adjust your tax basis (the cost, plus or minus certain factors) in your home. For example, you’d increase your basis to reflect certain closing costs, including:

  • Abstract fees
  • Charges for installing utility services
  • Legal fees
  • Recording fees
  • Surveys
  • Transfer or stamp taxes
  • Owner’s title insurance

For more information, see IRS Publication 530.

Tax treatment of home improvements and repairs

Home improvements and repairs are generally nondeductible. Improvements, though, can increase the tax basis of your home (which in turn can lower your tax bite when you sell your home). Improvements add value to your home, prolong its life, or adapt it to a new use. For example, the installation of a deck, a built-in swimming pool, or a second bathroom would be considered an improvement. In contrast, a repair simply keeps your home in good operating condition. Regular repairs and maintenance (e.g., repainting your house and fixing your gutters) are not considered improvements and are not included in the tax basis of your home. However, if repairs are performed as part of an extensive remodeling of your home, the entire job may be considered an improvement.

Exclusion of capital gain when your house is sold

If you sell your principal residence at a loss, you generally can’t deduct the loss on your tax return. If you sell your principal residence at a gain you may be able to exclude some or all of the gain from federal income tax.

Generally speaking, capital gain (or loss) on the sale of your principal residence equals the sale price of your home less your adjusted basis in the property. Your adjusted basis is the cost of the property (i.e., what you paid for it initially), plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes.

If you meet all requirements, you can exclude from federal income tax up to $250,000 ($500,000 if you’re married and file a joint return) of any capital gain that results from the sale of your principal residence. Anything over those limits is generally subject to tax. In general, this exclusion can be used only once every two years. To qualify for the exclusion, you must have owned and used the home as your principal residence for a total of two out of the five years before the sale.

For example, you and your spouse bought your home in 1981 for $200,000. You’ve lived in it ever since and file joint federal income tax returns. You sold the house yesterday for $350,000. Your entire $150,000 gain ($350,000 – $200,000) is excludable. That means that you don’t have to report your home sale on your federal income tax return.

What if you fail to meet the two-out-of-five-year rule? Or what if you used the capital gain exclusion within the past two years with respect to a different principal residence? You may still be able to exclude     part of your gain if your home sale was due to a change in place of employment, health reasons, or certain other unforeseen circumstances. In such a case, exclusion of the gain may be prorated.

Additionally, special rules may apply in the following cases:

  • If your principal residence contained a home office or was otherwise used partially for business purposes;
  • If you sell vacant land adjacent to your principal residence;
  • If your principal residence is owned by a trust;
  • If you rented part of your principal residence to tenants, or used it as a vacation or second home; or
  • If you owned your principal residence jointly with an unmarried individual

Note: Members of the uniformed services, foreign services, and intelligence community, as well as certain Peace Corps volunteers and employees may elect to suspend the running of the two-out-of-five-year requirement during any period of qualified official extended duty up to a maximum of ten years. Read here about other key benefits for military members and their families.

You should take advantage of whatever tax benefits you qualify for as a homeowner and contact BFSG and/or your tax professional to review your current tax return to make sure you are maximizing your tax benefits.

Prepared by Broadridge Advisor Solutions. Copyright 2021. Edited by BFSG, LLC.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.