Employers have many different options when it comes to employee retirement plans.
Of course, the most popular option is a 401(k) plan that enables employees to contribute – and employers to contribute or match – a portion of their wages to individual accounts. The only drawback is that these plans typically have annual compliance requirements and certain contribution limits.
Let’s take a look at the safe harbor provision that applies to these plans and how it affects employees.
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What Is a Safe Harbor Plan?
Employers that offer 401(k) plans must ensure that they do not discriminate in favor of owners, officers or highly compensated employees. In order to retain their tax-qualified status, companies must verify compliance with several annual tests, including coverage tests, ADP/ACP tests, top-heavy tests and contribution/deduction limit tests.
Safe harbor 401(k)s are a type of plan that avoids most annual compliance tests, as well as the fees and time it takes to complete these tests. For employees, safe harbor plans also ensure that everyone – including highly compensated employees – can make maximum contributions and 100% of all contributions are immediately vested.
Typically, there are three types of safe harbor 401(k) plans:
- Non-Elective: Eligible employees receive an annual employer contribution of three percent of their salaries that is immediately 100% vested. The employee receives the employer contribution regardless of whether or not they contribute to the plan.
- Basic Match: Employers match 100% of the first three percent of each employee’s contribution and half of the next two percent. Employees are required to contribute to their 401(k) plans in order to qualify for the match.
- Enhanced Match: Employers match 100% of the first four percent of each employee’s contribution. Employees are required to contribute to their 401(k) plans in order to qualify for the match.
The Setting Every Community Up for Retirement Enhancement Act, commonly known as the SECURE Act, eliminated the notice requirement for non-elective safe harbor plans, and employers are allowed to switch to a safe harbor 401(k) plan with non-elective contributions prior to 30 days before the end of the plan year.
To learn more on how the SECURE Act could affect your retirement planning, check out this article.
Benefits and Drawbacks
Safe harbor 401(k) plans are common among businesses that have struggled with compliance issues in the past or businesses with highly compensated employees who are limited in the amount they can contribute. On the other hand, these plans require a steady enough income to support employer contributions and eliminate the ability to vest over time.
The most important benefits include:
- Highly compensated employees – including owners or those earning more than $130,000 per year – can max out their retirement contributions. If a plan fails compliance testing without a safe harbor provision, the top earning employees have contribution limits that are typically equal to 2% of the average of all employees.
- Businesses can avoid the time and cost of annual compliance tests while ensuring that they don’t suffer from any penalties from non-compliance. If you’re an owner or officer, these benefits can ensure that you’re not wasting money that could be contributed to 401(k)s or issued via other forms of compensation.
The most important drawbacks include:
- Employer contributions are immediately 100% vested, meaning that employees can take their money with them when they leave the company, which isn’t possible for plans where vesting occurs over time. However, employers can design plans to limit matching contributions to only those employees who defer compensation.
- Employer contributions are required each year, so the business should have a reliable, steady stream of income. If the business foresees any difficulty matching funds over time, you may want to consider a different type of 401(k) plan.
Note: The fact that 100% of employer contributions are immediately vested could be seen as a positive for employees since it provides them with more flexibility.
The Bottom Line
Safe harbor 401(k) plans are a great way for businesses to avoid the time and expense of annual compliance tests, but there are some important drawbacks to consider. For employees, safe harbor plans are typically beneficial since they enable all employees to maximize their contributions, and employer contributions are immediately and fully vested.
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