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What is a safe harbor 401(k), and can your business benefit from one?

Mar 31, 2022

This article was co-written by Mitchell Guralski, AIF®, CRPS®, CFP®, a financial advisor at Wipfli Financial Advisors, LLC.

Have nondiscrimination testing and low employee participation restricted your ability to save contributions in your 401(k) plan? Electing safe harbor status may be able to help.

Safe harbor 401(k) plans are a special type of 401(k) that can benefit small businesses. By waiving certain IRS testing requirements, safe harbor 401(k) plans make it much easier for owners and highly compensated employees to maximize contributions to their 401(k) plan.

While there are added benefits, there are also requirements associated with such plans to take into consideration. Understanding both will help ensure your business makes an educated choice in whether to implement a safe harbor 401(k).

The standard 401(k) vs the safe harbor 401(k)

In many ways, the standard 401(k) plan and a safe harbor 401(k) plan are the same. Employees can contribute dollars from their paycheck and choose from a list of investment options to help grow their retirement account.

There are also several key differences. First, safe harbor 401(k) plans are not subject to all of the same IRS nondiscrimination tests that standard 401(k) plans are.

The actual deferral percentage (ADP), actual contribution percentage (ACP) and top-heavy tests are designed to ensure owners or highly compensated employees (HCEs) are not receiving an unproportionally large benefit compared to non-highly compensated employees (NHCEs). When a company fails these tests, it must take corrective action, often by distributing excess contributions to the owners and HCEs (a taxable event) or by making a nonelective contribution to all NHCEs.

Low contribution and participation rates from NHCEs can make it difficult to pass these tests and therefore directly limit how much owners or HCEs can save.

Electing safe harbor status allows companies to generally avoid these testing requirements, meaning owners and HCEs can save as much as they’d like (subject to the annual IRS deferral limits), without fear of receiving a corrective distribution at the end of the year. This is especially beneficial for small businesses, which may not have a large number of NHCEs to offset the contributions of ownership.

Safe harbor 401(k)s require annual employer contributions

In exchange for this benefit, a company with a safe harbor 401(k) is required to make annual employer contributions to eligible employees.

These mandatory safe harbor contributions must be fully vested immediately. This means an employee will never forfeit any safe harbor contributions upon separation, regardless of their years of service. (Note that you can still implement a vesting schedule on any employer contributions made in addition to the safe harbor employer contributions).

The required employer contribution can come in one of two forms:

Non-elective contribution

All eligible employees must receive an employer contribution of at least 3% of their compensation, regardless of how much the employee saves from their own paycheck. If an eligible employee does not contribute at all, they are still entitled to the 3% employer contribution.

Matching contribution

This safe harbor option requires the company to provide an employer contribution only to eligible employees who elect to contribute to the plan through payroll deductions. These employee contributions are referred to as employee elective deferrals. There are three matching contribution types:

  1. Basic safe harbor match: This is an employer dollar-for-dollar matching contribution on elective deferrals on the first 3% of the employee’s compensation plus a 50% matching contribution on elective deferrals on the next 2% of employee’s compensation.
    Employee elective deferral Required employer match
    0% 0%
    1% 1%
    2% 2%
    3% 3%
    4% 3.5%
    5%+ 4%
  2. Enhanced safe harbor match: This employer matching safe harbor contribution is the simplest option. It’s a dollar-for-dollar match on elective deferrals of at least the first 4% of the employee’s compensation. This can be increased to a dollar-for-dollar match on elective deferrals up to a maximum of 6% of compensation.
    Employee elective deferral Required employer match
    0% 0%
    1% 1%
    2% 2%
    3% 3%
    4% 4%
  3. Automatic safe harbor match: This safe harbor matching structure is unique in several ways. It provides for a dollar-for-dollar matching contribution on elective deferrals on the first 1% of compensation and a 50% matching contribution on elective deferrals on the next 5% of compensation. At the maximum elective deferral of 6%, it provides for a 3.5% matching contribution.
    This formula requires the employer to use an auto-enrollment feature, which automatically deducts a stated percentage (generally 3%) from an employee’s paycheck if an election is not made (without their consent — but with disclosure provided that allows them to opt out of the automatic payroll deduction). Additionally, this is the only safe harbor contribution option that allows for a vesting schedule of up to two years.
    Employee elective deferral Required employer match
    0% 0%
    1% 1%
    2% 1.5%
    3% 2%
    4% 2.5%
    5%+ 3%
    6%+ 3.5%

Could you benefit from safe harbor?

While safe harbor 401(k) plans require mandatory employer contributions annually, they ensure owners and highly compensated employees can fully participate in the beneficial income tax and retirement savings strategies that make 401(k) plans so popular. In addition, it greatly reduces administrative complexity and employer involvement through streamlined processes.

If you’re interested in learning more or getting started, Wipfli can help you determine whether a safe harbor 401(k) plan is a good choice for you and your business, which contribution type may work best for your situation, and how the safe harbor plan works in concert with your business and personal retirement goals. Visit our website to learn more.

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Wipfli Financial Advisors, LLC (“Wipfli Financial”) is an investment advisor registered with the U.S. Securities and Exchange Commission (SEC); however, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. Wipfli Financial is a proud affiliate of Wipfli LLP, a national accounting and consulting firm. Information pertaining to Wipfli Financial’s management, operations, services, fees and conflicts of interest is set forth in Wipfli Financial’s current Form ADV Part 2A brochure and Form CRS, copies of which are available from Wipfli Financial upon request at no cost or at www.adviserinfo.sec.gov. Wipfli Financial does not provide tax, accounting or legal services.

Wipfli LLP and Wipfli Financial, although affiliated companies, are separate entities.

Author(s)

Thomas Krieg, CPA
Partner
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