K.I.S.S.: Keep It Simple and Straightforward with Safe Harbor Plan Designs

Safe Harbor Plan Design - Delaware 5500 AuditorPosted by Maria T. Hurd, CPA

Most employers think that the maximum amount every participant can contribute to their 401(k) plans as a deferral from their own salary for 2012 is $17,000 plus $5,500 as a catch-up contribution if they are 50 or over. Unfortunately, the maximum limit may be cut back for the employer’s Highly Compensated Employees (HCEs) if certain rather complicated nondiscrimination testing is not satisfied. Many employers are dismayed to find out after the end of the plan year that their HCEs must get a refund of a portion of their deferrals because the discrimination testing has not been satisfied. The refunds of deferrals to the HCEs in such situations can be avoided only if the employer decides to make certain fully vested non-elective contributions to the non-highly compensated employees (NHCEs), so that the plan will satisfy the nondiscrimination testing.

For purposes of retirement plans, an HCE is an employee who:

  • is a shareholder owning more than 5% of the voting power or value of the employer (attribution applies); or
  • any person who, during the preceding year received compensation in excess of an amount set forth in the Internal Revenue Code as annually adjusted for the cost of living. The amount is $110,000 and $115,000 and for 2011 and 2012, respectively.

This nondiscrimination testing that we have been discussing is called the ADP test, which compares the average deferral percentage of the HCEs to the deferral percentage of the NHCEs. Under the required ADP test, the HCEs’ deferral percentage is limited to the greater of the Basic or the Alternative Tests. The Basic Test provides that the average ADP of the HCEs cannot exceed the average ADP of the NHCEs multiplied by 1.25. The Alternative Test provides that the average of the HCEs cannot exceed the average ADP of the NHCEs by more than the lesser of a) two times the ADP of the NHCEs or b) two percent plus the ADP of the NHCEs. The Aggregate Deferral Percentage (ADP) test can be summarized as follows:

  • If the average ADP of NHCEs is less than 2%, then the test used to determine the maximum average ADP of HCEs is the Alternative test – 2 times the average NHCEs ADP
  • If the average ADP of NHCEs is between 2% and 8%, then the test used to determine the maximum average ADP of HCEs is the Alternative test – plus 2% of the average NHCEs ADP
  • If the average ADP of NHCEs is more than 8%, then the test used to determine the maximum average ADP of HCEs is the Basic test – 1.25 times the average NHCEs ADP

Many small business owners want the opportunity to defer the maximum out of their own wages without having to contend with understanding and managing all the above abbreviations and technical terms, or convincing their employees that saving for retirement is in their own best interest. For those employers, a safe harbor plan may be the perfect solution. Safe harbor plans are exempt from discrimination testing, including the complex ADP test described above, as well as ACP tests, and top heavy testing, so long as the employer contributes one of the pre-approved safe-harbor formulas as follows:

Safe Harbor Match Contribution
The employer matches a minimum of 100%, or dollar for dollar of employee elective deferrals of up to 3% of pay, plus 50 cents for every dollar, or 50% of deferrals on the next 2% of their pay. The safe harbor match must be 100% vested at all times.

3% Non-Elective Safe Harbor Contribution
This contribution resembles a profit sharing contribution. The employer contributes 3% of pay to all eligible participants regardless of whether they have made a 401(k) contribution. The 3% non-elective contribution must be 100% vested.

Safe Harbor Automatic Enrollment Formula
The employer matches a minimum of 100%, or dollar for dollar of employee elective deferrals up to 1% of their eligible compensation plus 50 cents for every dollar, or 50% of deferrals between 1% and 6% of compensation. A two-year cliff-vesting schedule can be applied to automatic enrollment safe harbor match contributions.

Safe Harbor Notice
To take advantage of the safe harbor rules, the employer must comply with some administrative requirements including the distribution of a notice to all eligible employees at least 30 days before, but not more than 90 days before the beginning of each plan year. The notice must inform the employees of:

  1. the contribution formula that will be used (formulas described below);
  2. any other potential contributions under the plan;
  3. the plan to which the contributions are to be made;
  4. the method for participants to make elections;
  5. the withdrawal and vesting provisions applicable to the contributions

Ensuring the HCEs’ ability to defer $17,000 plus the related match or non-elective contribution can be a good first step into the endless plan design opportunities that are available. Although the safe harbor formulas curtail the employer’s ability to contribute the maximum annual addition of $50,000 that is available to profit sharing plans, numerous plan sponsors kiss goodbye the administrative complications of other plan designs, in favor of a Safe Harbor Plan that Keeps It Simple and Straightforward.

Photo by TaniaSaiz (License)

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