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Safe Harbor 401(k): The 2017 Guide for Business Owners

What’s a Safe Harbor 401(k)? How do you offer one? And why are there so many confusing acronyms?

Don’t worry. We’ve helped many companies set up compliant 401(k) plans, and we can walk you through all the basics. In this guide, we’ll explain everything from 401(k) compliance tests to what you’ll need to do to set up a Safe Harbor plan. It’s a little involved, though, so let’s start with some background information.

You probably already know that offering a 401(k) makes it easier for employees at your company to save more for retirement. But the government wants to make sure that everyone — not just highly compensated employees — gets to participate in a meaningful way. The goal of 401(k) plans, after all, is to prepare more Americans for retirement, not to create a tax break that’s exclusively for business owners and executives.

The IRS has set up a series of what it calls “nondiscrimination” tests that are designed to measure whether a 401(k) plan unduly favors highly compensated employees. If your plan were to fail one of these tests, it could mean making expensive corrections, a lot of administrative work, and potentially even refunding 401(k) contributions.

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So, what’s a Safe Harbor 401(k)?

A Safe Harbor 401(k) is a special kind of 401(k) that is exempt from nondiscrimination testing. It has certain built-in elements that help all employees save by requiring companies to contribute to their employees’ 401(k). When employers take this step to encourage more employees to participate, the IRS offers them “safe harbor” from both the nondiscrimination testing process and the consequences of failure.

If you’re thinking about offering a Safe Harbor 401(k), here’s what you need to know. Feel free to jump ahead if you’re trying to answer a specific question:

Ready? Okay, let’s dive in.

The three 401(k) nondiscrimination tests

Under a 401(k), employees can elect to defer some of their pay into a tax-advantaged account for their retirement.

Many employers make contributions in addition to what their employees defer. These contributions can be matching contributions, which are based on how much employees defer. Or they can be nonelective contributions, which are made whether or not an employee defers income to his or her 401(k). Sometimes these employer contributions are subject to a vesting period, which means that they’re forfeited if an employee leaves the company before a specific date.

Most employees like it when their employers contribute because they get additional money in their nest egg. And, many employers like making contributions because they keep employees happier, and because they qualify as business expenses which can be deducted when tax time rolls around.

As we said earlier, there are special tests that are applied to make sure a 401(k) plan is fair to rank and file employees — the three annual nondiscrimination tests:

  • The Actual Deferral Percentage (ADP) test
  • The Actual Contribution Percentage (ACP) test
  • The Top-Heavy test

According to the IRS 401(k) Plan Overview: “[These tests] verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.”

Highly compensated employees

Since two of these tests compare the way highly compensated employees and other employees are treated, let’s make sure we know who’s who. A “highly compensated employee” (HCE) is an individual who:

  • Owned more than 5% of the interest in the business at any time during the testing year or the preceding year (including certain family members via attribution rules), regardless of how much compensation that person earned or received, OR
  • Received compensation from the business of more than $120,000, during the preceding year AND, if the employer so chooses, was in the top 20% of employees when ranked by compensation.

For the purposes of nondiscrimination testing, everyone else is considered a “non-highly compensated employee” (NHCE).

Remember, the intent behind 401(k) plans is to encourage all employees to save money, not just the ones earning the big bucks. Say a company, Winterfell Consulting, offers a matching 401(k) contribution of 50% of the income an employee defers, until the deferral reaches 6% of their total W-2 income.

Safe Harbor Payroll Example

Is this arrangement discriminatory? Let’s take a closer look at the tests the IRS applies.

Measuring actual deferral percentage (ADP):

According to the IRS, this annual test “compares the average salary deferrals of highly compensated employees to that of non-highly compensated employees. Each employee’s deferral percentage is the percentage of compensation that has been deferred to the 401(k) plan.” ADP is calculated by dividing the amount an employee defers by their W-2 income.

Basically, this test measures how much income HCEs and NHCEs each contribute to their 401(k). For example:

ADP Calculation

In this case, Jon, the HCE, defers 10% of his compensation, while Sansa, Arya, and Bran, the NHCEs, contribute an average of 3%.

Measuring actual contribution percentage (ACP):

The ACP test is like the ADP test, except that it compares the employer contributions received by HCEs and NHCEs. ACP is calculated by dividing the company contribution to an employee by his or her W-2 income.

ACP Calculation

Here, Winterfell Consulting gives the HCE, Jon, a 3% total contribution, while NHCEs Sansa, Arya, and Bran receive an average contribution of 1.5%.

Applying the ADP/ACP tests

To pass the ADP and ACP tests, HCE deferral rates and employer contributions must fall below these thresholds:

  • If the ADP or ACP for NHCEs is 0%-2%, the ADP/ACP for HCEs must not be more than 2 times the NHCE rate
  • If the ADP or ACP for NHCEs is 2%-8%, the ADP/ACP for HCEs must not exceed the NHCE rate by more than 2%
  • If the ADP or ACP for NHCEs is greater than 8%, the ADP/ACP for HCEs must not be more than 1.25 times the NHCE rate

Note that the formula the IRS uses looks a little different from this. We find their language pretty hard to understand, so we reworked it to make it clearer. You can see their original testing formula in the IRS 401(k) Plan Fix-It Guide.

Both the ADP and the ACP tests cover the most recent full plan year. To apply these tests to the employees of Winterfell Consulting, let’s review the Winterfell NHCE’s ADP and ACP:

The ADP test: The NHCEs had an average ADP of 3%. That means the ADP of HCEs can’t be more than 5% (the 3% NHCEs deferred, plus 2%). Winterfell’s HCE defers 10%, so this plan fails the ADP test.

The ACP test: The NHCEs at Winterfell received an average contribution that was 1.5% of their W-2 income. To pass the test, HCEs can’t receive more than double the NHCE average — a maximum of 3% in this case. It turns out that the HCE receives 3%, so this plan passes the ACP test by the narrowest of margins.

Top-heavy test

The third test a plan must pass, the top-heavy test, is a little different from ACP and ADP because this test focuses on key employees within an organization, rather than HCEs. “Key employees” are defined by the IRS as:

  • An officer making over $175,000 in the plan year, OR
  • Someone who owns more than 5% of the business (including certain family members via attribution rules), OR
  • An employee owning more than 1% of the business (including certain family members via attribution rules) and making over $150,000 for the plan year

The top-heavy test is also different because it tests the plan’s balance as of December 31st of the previous year (or current year, if it is the plan’s first year). A plan fails the top-heavy test when the value of the assets in key employees’ accounts is more than 60% of all assets held in an employer’s 401(k) plan.

Returning to our example, let’s assume that this is the first year of the Winterfell Consulting plan and that the assets in the plan appreciate at 10% over the course of the year. Let’s also say that Jon Snow owns 100% of the company, which makes him the only key employee. Here’s what their assets add up to at the end of the year:

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There are total assets of $25,905 in the Winterfell plan, and the key employee has assets of $21,450 — about 83% of the total plan assets. Because more than 60% of the plan assets belong to the key employee, this plan fails the top-heavy test, too.

Correcting a failing 401(k)

If your plan fails any one of the above tests, there are some real consequences if you don’t take corrective action. The IRS 401(k) Fix-It Guide has useful information on all kinds of situations you may encounter, but for the ADP and ACP tests, its guidance recommends one of these courses of action:

1) Refund HCEs’ contributions to bring the average contribution rates down to the passing level, OR

2) Make qualified nonelective employer contributions (“QNEC”) to all NHCEs to bring their contribution rates up to the minimum percentage required to pass the test, OR

3) A combination of the two corrective actions above.

It’s important to know that if any refunds are made to any employees, they will be treated as taxable income. Going back to the example above, the Winterfell 401(k) failed the ADP and top-heavy tests.

Stay Compliant with a Safe Harbor Plan

Correcting an ADP failure

The plan failed the ADP test because, on average, the NHCEs deferred 3% of their W-2 income, which meant the HCE was only allowed to defer up to 5% of his income under the test. In this case, he deferred 10%.

The correction could be made two different ways. Winterfell Consulting could refund half of the HCE’s 10% deferral so that his deferral rate doesn’t surpass NHCEs by more than 2%. The refund would be distributed to the HCE as ordinary income in the year received.

Or if Winterfell makes appropriate Top-Heavy corrections of 3% for the same year the plan failed ADP (note: the discretionary matching may not suffice here), then a smaller correction would be made for the ADP failure, as the top-heavy corrections would bring up NHCE ADP rates to 6%. As a result, the HCE limit would be raised to 8%, and only 2% of the HCE’s pay would need to be refunded from his account.

Correcting a top-Heavy failure

The Winterfell 401(k) failed the top-heavy test because more than 60% of the plan assets belonged to the key employee. It’ll be considered top-heavy for the next plan year (and this plan year if it’s the plan’s first year in existence), and certain employer contributions will need to be made up to 3% of non-key employees’ compensation for each year the plan is top-heavy.

If Winterfell’s matching equals 3% of compensation paid for each employee at the end of the each year, then no further contributions need to be made to correct a top-heavy failure for that year.

Setting up a Safe Harbor 401(k)

Does passing these tests seem like a bit of a pain? If so, a Safe Harbor 401(k) might be a better way to go because it generally allows your plan to skip them altogether.

Safe Harbor plans require that your plan creates incentives to encourage more of your employees to take advantage of your 401(k). This requirement is important because Americans are abysmal at saving for retirement. According to the Economic Policy Institute (EPI), close to half of all American families don’t have any retirement savings, and among families nearing retirement, the median savings is only $17,000.

In exchange for letting your plan avoid nondiscrimination testing, you’ll have to follow some rules to make sure your plan benefits all your company’s employees.

If these requirements are at all confusing, we’d be happy to help. Schedule a quick consult to get hands-on help setting up your 401(k).

Requirements for a Safe Harbor 401(k)

The main requirement for a traditional Safe Harbor 401(k) is that the employer must make contributions and those contributions must vest immediately. Contributions can take three different forms, the first two of which are matching, which means employees must defer funds to their accounts in order to receive contributions. The third option requires your company to make a contribution, even if employees don’t defer any of their income into their plan.

Here are the contribution minimums under different plan types:

1. Basic matching: The company matches 100% of all employee 401(k) contributions, up to 3% of their compensation, plus a 50% match of the next 2% of their compensation

2. Enhanced matching: The company matches at least 100% of all employee 401(k) contributions, up to 4% of their compensation (not to exceed 6% of compensation)

3. Non-elective contribution: The company contributes at least 3% of each employee’s compensation, regardless of whether employees make contributions

This is what the matching and nonelective contributions would look like for an employee under the three different Safe Harbor formulas. The employee in this case is Winterfell Consulting’s Jon Snow, who earned $150,000 of income on his W-2 form during the plan year:

Safe-Harbor-401k-Matching-Formulas

Note that these contributions are only the minimums. For example, if a more generous employer matched up to 6% of employees’ pay, it would still qualify as Safe Harbor.

Right way to 401(k)

Additional Safe Harbor requirements

Making contributions to your employees’ 401(k) is the most notable Safe Harbor requirement, but there are additional rules surrounding when and how you offer your plan.

Safe Harbor deadlines
For new plans, October 1 is the final deadline for starting a new Safe Harbor 401(k). But, don’t wait to set up your plan a few days before the deadline because you’re also required to notify your employees 30 days before the plan starts and it can take a week or more to set up your plan. So, make sure you talk to your administrator well before September 1.

Important dates for new plans:

  • August 30, 2017: Deadline for setting up your Safe Harbor 401(k) Plan for the existing year
  • September 1, 2017: 30-day notice must be sent to employees
  • October 1, 2017: Safe Harbor 401(k) Plan is effective and exempt from nondiscrimination testing for 2017

If you want to add a Safe Harbor provision to an existing 401(k), your administrator can make a plan amendment that does into effect January 1 of any year. Remember, there is an employee 30-day notice requirement, and it may take some time for your administrator to amend the plan, so try to get this taken care by the end of November to go into effect January 1.

Important dates for existing plans

  • November 30, 2017: Deadline for requesting the addition of a Safe Harbor provision to your 401(k) plan for the following year
  • December 1, 2017: 30 day notice must be sent to employees
  • January 1, 2018: Safe Harbor provision takes effect and exempts the plan from nondiscrimination testing

Employee notice requirements
Each eligible employee must be notified in writing about their rights and obligations under the plan annually. Notice must be given within a reasonable amount of time — at least 30, but not more than 90 days — before the beginning of the plan year.

Making mid-year changes to a Safe Harbor plan
If you already offer a Safe Harbor 401(k) plan but would like to make changes, there are special rules that you need to follow. All the details for mid-year changes are included in IRS Notice 2016-16, but these are the basic things the IRS requires:

  • Give employees an updated Safe Harbor notice that describes any changes. Notice should be given 30 to 90 days before the changes go into effect.
  • Give each notified employee at least 30 days to change their cash or deferral election.
  • A combined notice may be provided.

Once you’ve satisfied the notice rules above, you may be able to make changes to certain aspects of the plan including, for example, increasing future safe harbor non-elective contributions from 3% to 4%, or changing the plan entry date for eligible employees from monthly to quarterly.

Several types of changes are not permissible during the year, however, so review the rules carefully if you wish to amend your plan.

Is a Safe Harbor 401(k) right for my company?

Good question! In general, Safe Harbor 401(k) plans are a good choice for companies that do any of the following:

  • Plan to match employee contributions anyway
  • Worry about passing nondiscrimination testing
  • Fail the ADP, ACP, or Top-Heavy tests
  • Have low participation among NHCEs and non-key employees
  • Care deeply for the wellbeing of their employees

In terms of pros and cons, the biggest downside to offering a Safe Harbor 401(k) is that the cost of the contributions your company will make. It's possible they could increase your overall payroll by 3% or more if all employees participate.

But many companies think the upside more than outweighs the cost. Offering a Safe Harbor plan will give you happier employees, tax savings, certainty that your plan won’t fail testing, and more retirement savings for everyone (including you).

Talk to a 401(k) Specialist