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Focus on Safe Harbor 401(k) Plans

C Johnson 2014
Charlene S.  Johnson, MBA, CPC, QPA, QKA®, QPFC, TGPC, ERPA
Vice President, Senior Retirement Consultant
[email protected]
(585) 419-0670 x50690

The IRS has launched an examination project focused on 401(k) plans that operate under a safe harbor design. A 2010 IRS compliance check revealed that a high percentage of employers sponsoring safe harbor 401(k) plans may not be making the required contributions to those plans. To help safe harbor plan sponsors vet their plans, and for employers who are considering a safe harbor design, here is a review of the safe harbor requirements.

A safe harbor design allows a 401(k) plan to avoid annual nondiscrimination testing on pretax salary deferrals and employer matching contributions. Typically, a 401(k) plan that fails nondiscrimination testing must refund contributions to highly paid employees or recharacterize them as after-tax contributions if the plan allows. Highly compensated employees’ annual contributions are reduced, and they are forced to pay income taxes they weren’t expecting.

The Trade-off — Required Contributions

In exchange for relief from the nondiscrimination testing requirements and higher contributions for highly compensated employees, a safe harbor plan sponsor must either (1) make a nonelective contribution of at least 3% of compensation for each nonhighly compensated employee eligible to participate in the plan or (2) make matching contributions under a qualifying matching formula. The basic matching formula is 100% of the first 3% of compensation deferred, plus 50% of deferrals between 3% and 5% of compensation.

The rules are a little different for a plan with a qualified automatic contribution arrangement (QACA). For these plans, the safe harbor matching contribution formula is a 100% match on the first 1% of compensation deferred and a 50% match on deferrals between 1% and 6%. Participants may be required to have two years of service before becoming vested in QACA contributions. The minimum employee deferral percentage must start at not less than 3% and, after two plan years of participation, increase at least one percentage point annually to no less than 6% (with a maximum of 10%) unless the participant elects otherwise.

Review your employer contributions for the year so far and the contributions you plan to make for the remainder of the year to determine whether you are on track to meet the applicable requirements. You can reduce or stop safe harbor matching contributions during a plan year if you give your participants at least 30 days’ notice so they can change their elective deferrals if they want to, but you’ll have to perform annual nondiscrimination testing for the entire plan year.

Other Safe Harbor Requirements

You must provide a notice of rights and obligations under your safe harbor plan to all eligible employees between 30 and 90 days before the start of each plan year. Employees who will become eligible during the year must be given reasonable advance notice. In addition:

  • All safe harbor contributions are immediately 100% vested.
  • You can’t set conditions on the receipt of safe harbor contributions — for example, that plan participants be employed on the last day of the plan year or work at least 1,000 hours during the plan year. (However, the plan can have minimum age and service requirements that employees must meet before they are eligible for plan participation.)
  • Safe harbor contributions generally can’t be available for in-service withdrawal before age 59½.
  • Plan documents must state whether safe harbor or non-safe harbor testing will be used.

Changing Plan Design

If your 401(k) plan isn’t currently a safe harbor plan but you are thinking it would be advantageous to operate under a safe harbor design, be aware that safe harbor provisions cannot be added to an existing 401(k) plan during a plan year. Rather, you must amend your plan to add a safe harbor design for the next plan year. The amendment must be adopted before the first day of the new plan year.