Did you know that Safe Harbor 401(k) plans are automatically deemed to pass certain annual compliance tests? This type of plan can help streamline administration and provide peace of mind for plan sponsors but can be costly as certain minimum contributions must be made to employees. Read on to learn more about the costs and benefits of Safe Harbor 401(k) plans.

Benefits of Safe Harbor 401(k) Plans

Each year, qualified retirement plans must be tested to demonstrate that they pass various compliance tests required by the Internal Revenue Service (IRS).  For most plans, this means that the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests must be performed each year. These tests compare the average rate of employee deferrals (pre-tax and Roth) or matching contributions as a percentage of compensation for highly compensated employees to that of non-highly compensated employees. This process can be time consuming for plan sponsors and may be costly if there are testing failures to correct. However, if a plan meets specific criteria described in the Internal Revenue Code (IRC), it will be deemed to satisfy certain nondiscrimination tests, depending on the exact nature of the contributions provided. Such a plan is commonly known as a “Safe Harbor 401(k)” plan.

Many plan sponsors choose to operate Safe Harbor 401(k) plans to take advantage of the streamlined plan administration and reduced annual compliance testing burdens. This is particularly helpful for plans which otherwise might be expected to fail testing based on employee demographics or other factors. Plan sponsors who wish to prioritize stability and avoid corrections may consider a Safe Harbor 401(k) design.

Safe Harbor 401(k) Plan Requirements

In order to meet the Safe Harbor 401(k) requirements, participants must receive matching or nonelective contributions under certain allowable formulas.

Safe Harbor 401(k) Nonelective Contributions

Plan sponsors may satisfy the Safe Harbor 401(k) contribution requirement by providing a nonelective contribution equal to 3% of compensation for each eligible employee, regardless of whether that employee has elected to make deferrals. This contribution may be more costly for plan sponsors as the population of employees eligible to receive the nonelective contribution may be larger (sometimes significantly so) than the population deferring, but such a contribution may be easier to administer, and the cost is likely to be more predictable. Additionally, Safe Harbor 401(k) nonelective contributions must be immediately vested.

Safe Harbor 401(k) Matching Contributions 

Alternatively, plan sponsors may choose to provide a matching contribution in order to satisfy the Safe Harbor 401(k) requirements as long as it meets certain criteria. Plan sponsors typically select one of the formulas described below: 

• Basic Safe Harbor 401(k) Matching Contribution Formula: Many plan sponsors choose to implement the “basic” matching formula described in the IRC, under which employees receive a matching contribution equal to 100% of deferrals up to the first 3% of compensation and 50% of the next 2% of compensation deferred. Matching contributions made under this formula must be immediately vested.
• Enhanced Safe Harbor 401(k) Matching Contribution Formula: Plan sponsors may also choose to implement an Enhanced Safe Harbor 401(k) matching contribution formula. Enhanced Safe Harbor 401(k) matching contribution formulas are required to be at least as generous as the Basic Safe Harbor 401(k) formula (including immediate vesting) but are also subject to certain other limitations. One of the most common examples of an Enhanced Safe Harbor 401(k) matching contribution formula in the market today is a matching contribution formula equal to 100% of deferrals up to the first 4% of compensation.  
• Qualified Automatic Contribution Arrangement Formula: Alternatively, a plan sponsor may wish to implement an automatic enrollment feature to increase participation in the plan. If certain requirements are met, an automatic enrollment feature may be considered a Qualified Automatic Contribution Arrangement (QACA), which is also a Safe Harbor 401(k) plan. In a QACA plan, the “basic” Safe Harbor 401(k) matching contribution formula is 100% on the first 1% of compensation and 50% on the next 5% of compensation deferred. One benefit to QACAs is that the Safe Harbor 401(k) matching contributions are not required to be 100% vested until after a participant completes two years of service.

There are benefits and drawbacks to both nonelective and matching contributions in Safe Harbor 401(k) plans. The best approach for a given Safe Harbor 401(k) plan to satisfy the Safe Harbor 401(k) contribution requirement will depend on the plan sponsor’s exact circumstances. 

Additional Considerations

There are many important considerations for plan sponsors when choosing to offer Safe Harbor 401(k) plans. One is that employer contributions are subject to immediate or two-year vesting, reducing the ability of employers to rely on forfeited contributions to pay plan expenses or fund future employer contributions. Additionally, should employers wish to suspend or eliminate their Safe Harbor 401(k) contributions in the middle of the year, the 401(k) plan would lose its Safe Harbor 401(k) status for the entire year and compliance testing would therefore be required.

Plan sponsors should also consider timing and notice requirements that apply to Safe Harbor 401(k) plans. For plans providing a Safe Harbor 401(k) matching contribution, notices must be provided to eligible employees describing their rights and obligations under the plan as well as certain plan features.  Safe Harbor 401(k) plans utilizing nonelective contributions to satisfy the Safe Harbor 401(k) contribution requirement were historically required to send notices also, but the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) eliminated this notice requirement for those plans. Additionally, while certain types of mid-year changes to Safe Harbor 401(k) plans are still prohibited, the SECURE Act also narrowed that list thereby allowing more mid-year changes. The SECURE Act also increased flexibility by providing a previously unavailable option for plan sponsors to implement Safe Harbor status as late as the end of the following plan year. These provisions should remove some of the obstacles plan sponsors have traditionally faced when operating Safe Harbor 401(k) plans.

Safe harbor 401(k) plans are also subject to certain other restrictions, such as a specific definition of compensation, vesting requirements, and administrative procedures around automatic enrollment, if included. While Safe Harbor 401(k) plans can make life easier for plan sponsors, they can also create headaches if not operated properly.

Takeaways

Now that you’re “in the know”, you can understand why Safe Harbor 401(k) plans are a popular choice for plan sponsors, with good reason, but they aren’t necessarily the right choice for every plan sponsor. Plan sponsors must consider whether the cost savings of reduced nondiscrimination testing obligations as well as other benefits, such as potential employee retention, outweigh the costs and requirements associated with sponsoring a Safe Harbor 401(k) plan. If so, the flexibility to satisfy requirements using different types of contributions allows plan sponsors to design a plan that best meets the goals of their organization while minimizing time spent on compliance concerns.

The professionals at Alvarez & Marsal Taxand are uniquely qualified to assist you in determining whether a Safe Harbor 401(k) plan is the best solution to meet the needs of your organization. If you have any questions, please contact our dedicated qualified plan team.