Plan Sponsor Alert: Safe Harbor 401(k) Plans Make Sense for Many Businesses
What is a safe harbor 401(k) plan? As its name implies, it is supposed to give a plan sponsor peace of mind.
For a plan to be considered a safe harbor plan, the employer must provide a safe harbor match to all actively deferring participants or a non-elective contribution to every employee, regardless of their status as a retirement plan contributor. These plans are popular for a number of reasons: safe harbor features help plans comply with non-discrimination rules, can help plans pass top-heavy tests if designed correctly, and allow the business owner or other highly compensated employees to maximize their contributions.
Safe harbor plans were designed specifically to solve for IRS tests that prevent owners and highly compensated employees (those who earn more than $120,000 per year or own 5% or more of the company) from saving at or near the maximum allowed by law ($18,500 in 2018, $24,500 for those 50 and older) while the average worker might save considerably less. Without a safe harbor plan, those who fail discrimination tests may have to reduce deferrals or even refund contributions back to their employees to comply. This could undermine employee confidence in the plan and ultimately hurt the overall plan health.
According to a 2016 study by SHRM, 68% of 401(k)s are safe harbor plans.1 But while the rules are straight forward and the benefits are significant, we still see many plans which have not yet implemented a safe harbor match of any kind. In this article, we will explore the requirements and share some examples of safe harbor plans.
Requirements of a safe harbor plan
While there are variations on the standard safe harbor plan, safe harbor plans generally offer a minimum match or non-elective contribution structured in one of three following ways:
- Basic match – the employer matches 100% of the first 3% and 50% of the next 2% of contributions to the plan;
- Enhanced match – the employer matches 100% of the first 4% contributed to the plan;
- Non-elective contribution – the employer contributes 3% to all eligible employees including those who do not elect to defer contributions.
To qualify as a safe harbor, matches must vest immediately and longer vesting schedules are not allowed3. Furthermore, plan sponsors are limited in their ability to make changes to a plan mid-year. While some changes are allowed, advance notice must be given to participants before making those changes.
Those seeking to launch a safe harbor 401(k) plan, or add a safe harbor provision to their plan, should not procrastinate. The deadline to establish a plan is October 1. In reality, you will need to begin the process much sooner as adding these provisions can take several weeks. Starting a new plan can take up to 12 weeks to implement.
In addition, employers are required to provide timely notice to all eligible employees. This notice must inform them about their rights and obligations under the plan and must be delivered at least 30 days and not more than 90 days prior to the beginning of the plan year2. For most plans that operate on a calendar year, the notice must come any time after October 1 and before December 1.
Safe harbor for other types of contributions
With many plans now offering automatic deferral arrangements, some organizations have elected to offer a Qualified Automatic Contribution Arrangement (QACA) with safe harbor provisions. QACA plans must include the following matches to meet the safe harbor requirements:
- 100% match on employee contributions up to 1% of compensation and a 50% match on contributions above 1% and up to 6% of compensation; or,
- A non-elective contribution of 3% of compensation for all participants including those who do not contribute to the plan4.
Discretionary match contributions can be made to safe harbor plans without violating discrimination testing provided the match does not exceed 6% of deferred compensation or 4% of compensation in total. Discretionary profit sharing may also be contributed to these types of plans.
Selecting a plan
Organizations with steady recurring revenues will find most safe harbor plans a good choice. The required match can be difficult for firms with less steady earnings. The cost of the safe harbor match can differ depending on the type of plan selected, and for some companies this can be an important factor. The amount of the match can also be impacted by participant dynamics including participation and deferral rates.
Consider the following simple example of a small company considering three types of safe harbor matches. In this example, there are two highly compensated employees including one who is able to make a catch-up contribution.
The example below considers a slightly larger company. To make this simple, we assume all employees in a class defer the same percentage. We use this average deferral rate to calculate the total costs for both the leadership and employee populations for the three different safe harbor matches. This example also assumes no catch-up contributions.
For many firms who offer a 401(k) benefit, there is a genuine desire to help participants save for the future. Safe harbor plans that offer a basic match do a good job of getting employees to defer a higher percentage to get the match. But for some companies with employees who are not participating or only deferring a small percentage of their income, the cost of the basic match may be less than a flat non-elective 3% contribution.
While there is significant upside to owners in adopting a safe harbor plan, the downside for many firms is the lack of flexibility. The match is not discretionary, it must be available to all participants (or in the case of the non-elective option all employees), and matches do not have vesting schedules. Once you’ve elected a safe harbor plan, changes require a notice period.
Safe harbor plans are complex and require plan sponsors to pay careful attention to the rules, to proactively communicate the plan’s provisions and obligations to employees, and to weigh the benefits against the potential costs of adopting a safe harbor plan. Plan sponsors can face significant costs by failing to heed the rules.
While the majority of plans today are safe harbor plans, a well-designed plan with good participant engagement can overcome some of the testing hurdles some plans face, and with appropriate monitoring, adjustments can be made to avoid mistakes. By working with the Bronfman Rothschild team to examine your organization’s financial circumstances and demographics, you can better determine if a safe harbor plan, and what type of safe harbor plan, is the right choice for your organization.