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You already know that a 401(k) is a very popular retirement plan and, like other plan designs, it allows employees to take advantage of tax deferrals on contributions and earnings while their money accumulates for retirement.
To enjoy this special status, the IRS put in place rules to assure that plans benefit rank and file employees and not just a company’s owners and highly compensated employees. These are called nondiscrimination rules and there are three tests we use each year to determine whether a plan measures up.
Here they are in a nutshell:
The ADP test – which stands for “Actual Deferral Percentage” looks at how the deferral rate for highly compensated employees compares to that of non-highly compensated employees. Typically, the deferral percent for highly compensated employees can’t be more than two points more than that of the non-highly compensated employees to pass this test.
The ACP test – which stands for “Actual Contribution Percentage” compares employer matching contributions between these two groups.
And the Top-Heavy test – which determines if the account balances of key employees is greater than 60% of the total assets held by the plan.
We know that the goal of many company owners is to maximize how much they can contribute each year to their retirement. So, to avoid uncertainty about this, many owners choose to make additional contributions for their employees in order to get a free pass on these non-discrimination tests. These are called “Safe Harbor” contributions.
A company can make a Safe Harbor contribution either through a matching formula or by making a non-elective contribution to all of their employees. Let’s take a quick look at ways to do this:
Safe Harbor Match
To satisfy the requirement and encourage plan participation, an employer may choose to offer a Safe Harbor Match. The Basic Match formula provides a 100% match on the first 3% of deferral compensation, plus a 50% match on deferrals between 3% and 5%.
An Enhanced Match has to be at least as much as the Basic Match at all levels and is typically a match of 100% on the first 4% of deferral compensation.
The other Safe Harbor option is to make a contribution of at least 3% of annual compensation for all eligible employees. This includes those employees who don’t defer.
A quick note: Safe Harbor contributions must always be 100% vested. That means that employees can count these contributions in their balances without forfeiture upon termination of employment.
Adopting a Safe Harbor provision can help a plan in four important ways:
- It reduces plan maintenance costs by eliminating annual nondiscrimination testing requirements
- It allows highly compensated employees to maximize their deferrals
- It relieves a plan’s top-heavy status, and
- Its matching or nonelective contributions represent additional competitive benefits for employees
We encourage you to get in touch if you’d like to learn a little more about how Safe Harbor contributions can help make plans more successful.