Should Your 401k Plan be a Safe Harbor 401k Plan?
Business owners generally intend to fund the annual deferral dollar limit when they establish a 401(k) Plan. In 2018, the IRS tax code allows deferrals of $18,500 for participants under age 50 and deferrals of $24,500 if age 50 or older.
Whether or not the business owners and other highly compensated employees (HCEs) can retain their deferrals in the plan will depend on the deferrals made by the company’s rank and file employees. Being eligible for the plan is not enough to pass required testing–rank and file employees must also choose to defer at a rate that meets IRS compliance testing. When compliance tests specific for deferrals and employer match contributions do not pass, deferral/match refunds may be required. The refunds will be taxable income to the employee.
The good news is that the IRS tax code has an option which allows business owners/HCEs to make the maximum deferral amount without risk of a refund. The option promotes company goodwill with employees and provides increased retirement savings for all.
Adding a Safe Harbor provision to your 401k plan ensures business owners/HCEs at your company can take full advantage of the annual deferral dollar limit. The deferral specific testing passes automatically as long as you provide the required notices to participants and fund the Safe Harbor contribution.
There are two possible Safe Harbor contributions:
Safe Harbor Match
- Deferrals up to 3% of compensation are matched at 100%
- Deferrals from 3% to 5% are matched at 50%
- Maximum Safe Harbor Match is 4% of compensation
Safe Harbor Non-Elective
- 3% of eligible plan year compensation
Each Safe Harbor contribution has its own pros and cons, and the decision of which to choose depends on your retirement goals and benefit philosophy.
We’ll go through a brief description of each:
Safe Harbor Match
The Safe Harbor Match incentivizes employees to save for retirement by matching their deferrals into the plan. You may do the Basic Safe Harbor Match outlined above or do a straight 100% match on deferrals up to 4% of compensation. Deferrals over 5% of compensation are not matched. The Safe Harbor Match is capped at 4% of compensation.
The pro of committing to the Safe Harbor Match is that it rewards those employees who make the decision to contribute part of their wages to the plan for their retirement, and makes them have some skin in the game to receive the benefit. The con is that the employer funding costs will fluctuate depending on employee deferral elections.
Safe Harbor Non-Elective (SHNE)
The Safe Harbor Non-Elective (SHNE) contribution is 3% of compensation to all eligible plan participants. Any employee who has met the eligibility requirements to be in the plan would receive this contribution. They do not have to make deferrals in order to receive it.
The pro of committing to the SHNE contribution is it’s easier for budgeting/planning purposes to project the employer funding costs. The con is that all plan participants will receive the SHNE so the funding costs may be higher than the Safe Harbor Match if only a few employees choose to make deferrals.
Additional considerations in choosing which contribution might be a better fit for your company are:
Is the main purpose of the plan to provide a vehicle for all employees to start saving for retirement without a need for the owners/HCEs to have maximum contributions?
- Safe Harbor Match is generally the contribution to use for this scenario.
Is the main purpose of the plan to provide a vehicle for the business owner/HCEs to make maximum deferrals and also receive maximum employer contributions?
- SHNE is generally the contribution to use for this scenario.
The maximum possible allocation to an individual is $55,000. If the goal is to have the business owner/HCEs receive close to or the maximum allocation, the SHNE contribution will usually be the better option due to other testing that must be done when working towards the higher allocation goals.
The maximum allocation includes the employee deferrals along with employer contributions. In addition to the Safe Harbor contribution, your Third Party Administrator (TPA) will calculate an Employer Profit Sharing contribution that will allow you and/or HCEs to receive the maximum allocation. Generally, a higher benefit/ lower funding cost ratio will result when the company uses the SHNE instead of the Safe Harbor Match. One just has to be fine with making contributions for employees even if they don’t elect to make deferrals. In a future article, we’ll tackle what some of these testing methods are and why they yield higher benefits.
A few final things to note. All Safe Harbor contributions made to the 401k plan are 100% vested. This means that the contributions immediately belong to the participants the same as their deferrals and they will receive the total amount as a distribution when they are eligible to take a distribution from the plan. Employees must be given notice of the Safe Harbor contribution at least 30 days before the end of the prior year (December 1st for calendar year-end plans), but not more than 90 days before year end.