Should You Consider a Safe Harbor 401(k)?

A safe harbor design allows a 401(k) plan to avoid annual nondiscrimination testing of employee elective contributions and employer matching contributions. If you are thinking of implementing a safe harbor 401(k) plan, the overview that follows may prove useful in your decision-making.

The Safe Harbor Design Advantage

A 401(k) plan generally must undergo actual deferral percentage (ADP) and actual contribution percentage (ACP) testing each year. In addition to allowing a 401(k) plan to avoid the administrative burden of conducting these tests, a safe harbor design may enable highly compensated employees (HCEs) to contribute more to the plan than they could if the plan were subject to nondiscrimination testing. Employers that might benefit most from a safe harbor 401(k) plan include:

  • Firms with highly paid employees who are not able to maximize their plan deferrals because of the low participation rates of lower paid employees
  • Companies already making employer contributions at or near the levels required to meet the safe harbor requirements
  • Employers required by law to make top-heavy minimum contributions

Contribution Requirements

Employers that choose a safe harbor plan design must satisfy certain employer contribution requirements. There are two basic options:

  • Make non-elective contributions of at least 3% of compensation on behalf of each non-highly compensated employee who is eligible to participate in the plan
  • Match 100% of employee elective contributions up to 3% of compensation and 50% of elective contributions between 3% and 5% of compensation

Sponsors may also use an enhanced matching formula. With an enhanced match, the aggregate amount of matching contributions at any given deferral rate must at least equal the aggregate amount of matching contributions made under the basic matching formula.

Whether the plan provides for matching or non-elective contributions, they must be fully vested when made.

Required Notices

A safe harbor plan must provide written notice of rights and obligations under the plan to eligible employees between 30 and 90 days before the beginning of each plan year. For employees who become eligible after the beginning of the plan year, the notice generally must be provided within the 90-day period ending on the employee’s entry date. Plans that provide for immediate eligibility and permit employees to begin deferrals on the date they become eligible may provide the notice as soon as possible thereafter.

Converting to a Safe Harbor Plan

Both new and existing retirement plans can use the safe harbor design. To convert an existing 401(k) plan, the employer must adopt an amendment converting the plan before the plan year the conversion will take effect. A newly established 401(k) safe harbor plan’s first plan year must be at least three months long (or less if the plan is established soon after the employer comes into existence).

Midyear Amendments

Once a 401(k) safe harbor plan is in place, employers have some flexibility to amend their plans during the year. Under IRS Notice 2016-16, a midyear change will not violate the safe harbor rules merely because it is a midyear change, provided it does not violate a list of specifically prohibited changes, and, in the event the change affects the plan’s required safe harbor notice content, applicable notice and election opportunity conditions listed by the notice are satisfied.

Specifically prohibited midyear changes include the following:

  • Increasing the number of years of service required for vesting in a qualified automatic contribution arrangement (QACA) plan
  • Reducing the number of employees currently eligible to receive safe harbor contributions
  • Changing the type of safe harbor plan (e.g., from a traditional safe harbor to a QACA or vice versa)

Also prohibited is changing the formula for matching contributions if it increases the amount of matching contributions or adds discretionary matching contributions. But the IRS allows increasing the match if the change is retroactively applied for the entire plan year and it’s based on compensation for the full year. In addition, the change must be adopted and participants must be given notice and an opportunity to change their deferrals at least three months prior to the plan year-end.

If the midyear change affects the required information in the safe harbor notice, the sponsor must then provide an updated safe harbor notice with a description of the midyear amendment and its effective date. Generally, a sponsor has between 30 and 90 days before the change becomes effective to provide notice to participants.

Reducing or Eliminating Contributions

Generally, for plan years beginning on or after January 1, 2015, a sponsor may reduce or stop making safe harbor matching or non-elective contributions if (1) the employer is operating at an “economic loss,”or (2) the safe harbor notice states that the plan may do so and that the reduction or elimination will not apply until at least 30 days after the notice is provided. (Additional requirements apply.) ADP and ACP testing will apply to all elective and matching contributions (including safe harbor matching contributions) made during the plan year.

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