401(k) plans are intended to provide comparable advantages for all employees, and there are numerous safeguards in place to make sure their benefits are allocated equitably. U.S. regulatory measures ensure that a company’s plan does not disproportionately benefit some employees over others, regardless of their income or ownership status. To evaluate whether the plan is administered in an even-handed manner, the IRS conducts annual nondiscrimination tests. Failure of any of these tests can result in significant — and costly — additional contributions or required corrective distributions to some employees.
There are three primary tests most people think of when they hear “nondiscrimination tests:” the Actual Deferral Percentage test, the Top-Heavy test, and the Actual Contribution Percentage test. All three tests judge a plan’s overall fairness toward the employees served, but they use different metrics, and measure different plan items (different types of contributions or account balances) to make these determinations. By comparing deferral rates, contributions and asset balances among highly compensated and non-highly compensated employees, they assess whether plans disproportionately benefit higher paid employees, such as management and owners.
Safe Harbor Plans
Failure of nondiscrimination testing can result in the plan having to make qualified nonelective contributions for employees that are not highly compensated. Your plan might even lose its qualified status — and the tax benefits that go along with it if rules are not met in terms of passing testing or taking proper corrective actions. Fortunately, safe harbor plans can help you avoid these tests by preemptively meeting requirements for fairness through the plan design itself. There are four different types of deferrals that employers can make through safe harbor plans: nonelective, basic, enhanced and qualified automatic contribution agreement (QACA). Adopting safe harbor design results in less administrative burdens, and as a result often results with lower administrative costs for the plan.
- Nonelective. A nonelective safe harbor plan requires employers to make automatic contributions to their employees’ plans that are equal to or greater than 3% of annual compensation for every employee eligible to participate. This type of plan benefits employees whether they choose to defer or not. If a plan sponsor wants to adopt a safe harbor design retroactively they can do so after the plan year (within certain parameters) if they raise the nonelective contribution to 4% of annual compensation for all eligible employees.
- Basic. A basic safe harbor plan features what’s known as a basic match. This means that employers simply match 100% of their employees’ contributions, up to 3% of their annual compensation plus 50% match on employee contributions on the next 2% of pay (for a total potential match of 4% on 5% of pay).
- Enhanced. An enhanced contribution is any contribution that’s greater than those offered by a basic safe harbor plan. This is typically a 100% match of up to 4% of an employee’s contribution. For growing businesses, these types of plans can be especially attractive to new talent with several competitive job offers under consideration. Vesting is immediate for nonelective, basic and enhanced match plans.
- Qualified Automatic Contribution Arrangement. QACA plans automatically enroll eligible workers (who can opt out) and employ an auto-escalation feature that increases employee contributions by 1% annually until they reach 6%. To qualify for this type of plan — and avoid nondiscrimination tests — employers must select one of two options. The first is for employers to match 100% of an employee’s contribution of the first 1% of their annual compensation, plus 50% of the employee’s contributions on the next 5% of compensation (for a potential total of a 3.5% match on 5% of compensation). The second option is to provide a nonelective contribution of 3% of annual compensation to all eligible employees, including employees who do not contribute. Vesting must take place within two years of employee service.
Why You Should Consider Safe Harbor
In addition to potentially saving you administrative work and your plan participants some administrative cost, safe harbor can also unlock savings opportunities for your highly compensated employees that may be presently limited while concurrently helping all of your employees save for retirement. For employees, most types of safe harbor plans guarantee fast or immediate vesting and allow them to potentially grow their nest eggs more quickly due to the provision of matching contributions. For employers, these attractive plans can fuel recruitment initiatives and boost employee morale by empowering workers with more robust tools to improve their financial wellness. Sponsors must weigh the tradeoff of increased payroll costs in light of lower administrative burdens and the eliminated risk of penalties resulting from failed nondiscrimination testing. Especially if you’re planning on offering a match anyway, you should consider the advantages a safe harbor plan offers.
That said, it is important to also consider alternative ways to meet your organizations’ goals. Safe harbor plan design can be a blunt, and sometimes limited, instrument that’s more expensive than necessary if the organization’s goals is really to ensure compensation replacement for a class of highly compensated employees. In many instances creation of a non-qualified plan may be a more precise tool to accomplish your organizational goals . . . and many times it’s much less expensive than the safe harbor design options. Regardless, it’s worthwhile to explore all of your options with your plan advisor.
The information presented here is for educational purpose only and is not intended to provide specific advice or recommendations for any individual, nor does it take into account the particular investment objectives, financial situation, or needs of individual investors. All examples are hypothetical and are for illustrative purposes only.
Lebel & Harriman Retirement Advisors is a separate entity from Retirement Plan Advisory Group (RPAG). Retirement Plan Advisory Group (RPAG) is a separate entity from Valmark Securities, Inc. and Valmark Advisers, Inc.