Is a Safe Harbor plan right for your client?
By Ethan Branum, QKA, CIP
I have an employer who has several highly compensated employees and wants to maximize their deferrals contributions as much as possible up to the limit, would a safe harbor plan be a good option?
The term “safe harbor” is used quite often in the retirement plan world. Generally, if you follow the safe harbor method or guidelines, then you will be “safe” from those requirements. There are two compliance tests that are required to be run in a 401(k) plan each year: the actual deferral percentage (ADP) test and the actual contribution percentage (ACP) test. These tests check for possible discrimination between two classes of employees: highly compensated employees (HCEs) and nonhighly compensated employees (NHCEs). On a very high level, the ADP test compares the average deferral rates between HCEs and NHCEs: the ACP test compares the amount of matching contributions and nondeductible employee contributions made on behalf of HCEs to the amount of such contributions made on behalf of nonHCEs. These two tests determine the average HCEs’ rates, which must be within a certain percentage of the NHCEs’ rates, according to IRS requirements. If a plan fails these tests, then refunds are issued to the HCEs in order to have the rates meet IRS requirements.
If a 401(k) plan meets the IRS requirements to be considered a safe harbor plan, the plan will be deemed to automatically pass the ADP and ACP tests, allowing the HCEs to contribute whatever they want to the plan without worrying about what everyone else is contributing.
What are the requirements to be a safe harbor plan?
To be considered a safe harbor plan, the plan must meet several requirements, including the following.
Employers must provide either a matching or a nonelective contribution. An employer can provide a matching contribution by using the “basic match formula”. This formula requires a contribution that equals the sum of 100 percent of the employee’s deferrals up to 3 percent of the employee’s compensation, plus 50 percent of the employee’s deferrals between 3 percent and 5 percent of the employee’s compensation. For example, if an employee contributes at least 5 percent, the employer can contribute 4 percent.
Employers can also contribute more under the “enhanced match formula”. In simple terms, the enhanced match formula may be different, but the outcome in total matching contributions must be the same or greater than under the basic match formula. In addition, an employer cannot require employees to defer more than 6 percent of their compensation to receive the full matching contribution.
Instead of making a matching contribution, an employer may make a 3 percent nonelective contribution. A nonelective contribution is based on the employee’s compensation and does not require an employee to contribute in order to receive it.
Employer contributions must be provided for the entire year based on the employee’s compensation for that full plan year. A few exceptions do apply, but employers must generally expect to fund the plan for the entire plan year, generally the calendar year.
Employer contributions must be 100 percent vested. Employees must be allowed to distribute these assets once they reach a distributable event under the plan document (such as age 59½, plan termination, or disability).
What are the pros and cons to becoming a safe harbor plan?
The pros include allowing HCEs to contribute any amount up to the maximum allowed (i.e., $20,500 plus $6,500 if age 50 or older for 2022). Employees will also receive employer contributions that are immediately 100 percent vested. Providing a nonelective contribution that doesn’t require employees to contribute anything may be a useful tool for employee retention and recruitment.
A con—from an employer perspective—is that a contribution is required, and there is a cost associated with the funding obligation. Depending on the company’s size and employee demographics, the funding obligation can be costly.
Offering a safe harbor plan can be a good option if the employer’s goal is to contribute as much as it can to a retirement plan and is ok with the safe harbor plan requirements.
