Safe harbor 401(k) plans – the basics

Valuable Information on 401ks, Pensions, ESOPs, Form 5500 Preparation + More

safe harbor 401(k), employee benefit plansIn a broad sense, the 401(k) is an investment vehicle for the masses. 401(k) plans offer millions of employees nationwide the ability to contribute directly from their paycheck into tax-advantaged investment accounts, and employers have the option to match a percentage of employee contributions (and many do). Properly utilized, the 401(k) vehicle is a stellar way to invest for retirement; however, as with any tax-advantaged structure, rules and regulations must exist to prevent abuse. Most 401(k) plans are subject to various compliance tests performed by plan sponsors to ensure that 401(k) plans are not operating for the primary benefit of highly compensated employees (HCEs). To avoid the stress of compliance testing and potential noncompliance, some plans choose to operate as safe harbor 401(k) plans. Safe harbor 401(k) plans are mostly similar to traditional 401(k) plans. A few of the primary caveats are listed below:

401(k) Pre-tax or roth contribution: which is better?

  1. First, employer contributions instantly vest. HCEs (think executives, senior officials, managers, owners, etc.) often serve long enough to vest in their employer matching contributions. Thus, in a plan not subject to compliance testing and therefore potentially “top heavy,” the IRS requires all ER contributions to be fully-vested, regardless of service time.
  2. Second, employers must match employee contributions up to 3% of an employee’s salary as well as 50% of an additional 2% of an employee’s salary. Moreover, an employee contributing 5% of their salary in a safe harbor plan would receive a 4% match (3% as well as half of the next 2%). This form of matching is referred to as the basic match. Alternatively, employers can use the enhanced match. The enhanced match can take many forms; however, it must pay a greater aggregate amount than the basic match, and the ratio of enhanced match contributions must not increase in proportion to employee contributions as employee contributions increase. Effectively, an enhanced match must amount to more than the Basic Match and must not increasingly award those who contribute more.
  3. Third, the ratio of HCE matching contributions in proportion to their elective contributions may not exceed that of NHCEs, assuming they both elect to contribute the same percentage of compensation.

While safe harbor 401(k) plans differ from traditional 401(k) plans in additional ways, the items above paint the broad strokes. While these plans are exempt from compliance testing, various safeguards must exist to ensure that NHCEs have access to the benefits of the plan. For small 401(k) plans, the safe harbor setup can make great sense. After all, in a small plan, it is relatively easy to reach imbalance in the plan when a few HCEs constitute a large portion of contributions.

For more on safe harbor plans, see the following items:

  • Internal Revenue Code Relating to “Top-Heavy” 401(k) Plans: IRC §416
  • Safe Harbor Rules: Treasure Reg § 1.401(k)-3
  • IRS: 401(k) Plan Overview

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Michael Veldhuizen