Pros and Cons of a Safe Harbor Plan

Let’s face it: no one loves a test – especially when IRS penalties are involved. Other types of 401(k) plans have to pass three tests:

• The Actual Deferral Percentage (ADP) Test:

  This limits the percentage of compensation that Highly Compensated Employees can defer into their 401(k) based on the average contribution rates of non-highly-compensated employees. This test can easily impact small business plans, particularly when there are not many non-HCEs.

• The Actual Contribution Percentage (ACP) Test:

  This test ensures that the employer matching contributions and any after-tax employee contributions for HCEs are not disproportionately higher compared to non-highly-paid employees.

• The Top-Heavy Test:

  This test ensures that key employees cumulatively hold less than 60% of the total plan balance. Key employees are defined based on ownership status, officer status, and compensation.

Is it an added headache and expense to pay for annual auditing? Yes. Is it a challenge for small businesses to pass these tests every year? It can be. If you fail the test, the IRS will give you specific instructions on how to remedy the situation. This could mean refunding some of the contributions back to HCEs or putting more money into non-HCE accounts, not to mention a 10% penalty.

Failures can be time-consuming and expensive to correct, which is why many businesses avoid the uncertainty altogether by opting for a Safe Harbor 401(k).

General Cons of a Safe Harbor 401(k)

• If you weren’t planning to make a match, the legal requirement to do so can make the plan feel prohibitively expensive for small business owners. Overall, the cost of payroll could go up by 3 percent. For instance, if you offered a 3% non-elective contribution for 10 employees earning $60,000 each, you would contribute $60,000 x 10 x 3% for a grand total of $18,000. If you’re using a match formula, it will be more difficult to predict the employee contributions, but it could be cheaper overall.
• Some employers like to use vesting as a way of securing loyalty from new workers, so the immediate vesting of the employee match can be a turnoff for some business owners. However, it should be noted there are ways of making profit-sharing contributions on a vesting schedule.
• There is no guarantee you’ll pass the Top-Heavy test. If the plan has only elective deferrals or nonelective contributions that satisfy ADP/ACP safe harbors, then the plan is not top-heavy. If the plan allocates a profit-sharing contribution, the plan may not be exempt, and top-heavy rules can apply. These rules can change from year to year.

Once you’ve decided that a Safe Harbor 401(k) is the way to go, you have a few different options to weigh.

Basic Matching

With the Basic formula, you provide a 100% “dollar for dollar” match on the first 3% of compensation contributed by employees, plus a 50% match on the next 2% contributed.

• Pro: Employees must actively participate in the plan and put money toward their retirement to benefit
• Con: Since the match is based on contributions, employer funding costs will fluctuate
• Con: You still have to make sure you can pass the top-heavy test

Enhanced Matching

With the Enhanced formula, you provide a 100% “dollar for dollar” match on contributions from 4-6% of compensation contributed by employees.

• Pro: Employees are encouraged to save aggressively for their retirement. They must invest to receive
• Con: Again, employer costs vary from year to year, depending on employee savings
• Con: There is no guarantee you’ll pass the top-heavy test

Non-elective Contribution

With the Non-Elective formula, you commit to a mandatory contribution of at least 3% of total compensation for all employees that meet the plan’s eligibility rules, regardless of whether or not they contribute to the plan.

• Pro: All employees benefit from the retirement plan, whether they choose to save or not
• Pro: The costs are at a fixed rate from year to year, which makes budgeting and planning easier
• Pro: Owners and HCEs have the potential to maximize their employee/employer contributions
• Con: Costs can be higher, considering all eligible employees receive maximum contributions

Is a Safe Harbor Plan for Your Small Business?

You should consider a Safe Harbor plan for your small business if you want to take care of your employees as a matter of good business principles or if you want to adopt a match program that is truly competitive. Maybe you’ve had a plan that has failed nondiscrimination testing in the past and you’d rather bypass the whole ordeal, or you currently have a low retirement savings participation rate you’d like to boost. Contact Ubiquity to learn more about the Safe Harbor 401(k), as well as alternatives like traditional 401(k) plans and Solo 401(k)s. If you have an existing plan, you can add a Safe Harbor provision by contacting us, too.