Safe Harbor Plans – A Smart Investment Strategy for Employees

For small business owners and highly compensated employees (HCEs), safe harbor plans allow them to maximize salary deferrals and employer contributions. Plus, they eliminate the need for IRS non-discrimination testing and top-heavy minimum contribution tests.

Employers can choose between three types of safe harbor plans – non-elective, essential match, or enhanced match. Each has its pros and cons.

Tax-Advantaged Savings

Business owners often opt for a safe harbor 401k plans because it helps them offer higher employee contributions without the IRS’s required compliance testing. The government establishes these tests to ensure that 401(k) plans don’t provide highly compensated employees (HCEs) with more incredible benefits than other employees.

A safe harbor 401(k) plan allows you to set up a plan that automatically passes these compliance tests by offering a fixed match of up to 4% of each participating employee’s salary deferral. For example, if an employee defers 5% of their salary, the employer will contribute up to 3% ($1,500).

The non-elective safe harbor contribution of 3% of your company’s salary also helps you incentivize key HCEs to participate by providing them with free money they are immediately vested in, even if they don’t make any elective deferrals to the plan. It can incentivize HCEs to stay at your business rather than seeking more flexible benefit offers from competitors.

The safe harbor plan requires you to notify eligible employees detailing their rights and obligations under the plan. This notification must meet content and timing requirements as outlined by the IRS. In addition, it is essential to remember that you can reduce or suspend the safe harbor contributions mid-year if needed, but only if doing so does not cause your business to operate at an economic loss.

Attract and Retain Employees

If you have difficulty attracting and retaining quality employees, a 401(k) with a safe harbor feature may be the answer. The feature allows your company to bypass annual non-discrimination testing for salary deferrals and employer contributions, making rewarding top performers easier and avoiding losing valuable staff members to competing offers.

Additionally, safe harbor plans let you offer a main matching contribution equal to 100% of the first 3% of deferred salary and 50% of the following 2%, so your workers’ pretax deferrals will be fully matched. It is much less than the typical 5% or 6% employer-provided contribution to traditional 401(k) plans.

For small businesses, a safe harbor plan can also give your company a free pass on specific tests compared to a traditional 401(k) because it is more difficult for the company to exceed the minimum contribution limits set by the IRS. It can make the plan more effortless and more affordable for your business.

While safe harbor features can benefit your company, the best way to avoid compliance issues is to roll out a 401(k) with automatic enrollment and an appropriate match formula to help you overcome non-discrimination test hurdles. That will require time and money but may be a more effective strategy for your business than simply adopting a safe harbor plan.

Tax-Free Earnings

When a company uses a safe harbor plan design, it avoids many of the IRS/DOL compliance testing requirements with traditional 401(k) plans. Precisely, a safe harbor plan satisfies the nondiscrimination tests for both employee elective deferrals and employer matching contributions without the need to conduct the Actual Deferral Percentage (ADP) test or the Actual Contribution Percentage (ACP) test each year to ensure highly compensated employees are not disproportionately advantaged in the plan.

A safe harbor plan also allows a company to make a non-elective contribution to all participants immediately 100% vested. It is an excellent option for small companies that want to offer an incentive for key employees while avoiding the additional costs of a profit-sharing contribution and the possible compliance failures that could arise with those types of contributions.

A safe harbor plan can also be a good solution for plans that fail the ADP or ACP tests or are top-heavy. However, the corrective distributions required of a plan with this status and a top-heavy minimum contribution are generally much smaller than a profit-sharing contribution, so a holistic review should always be performed before adopting a safe harbor plan design.

Enhanced Matching

Many small business owners find the perks of a safe harbor plan more valuable than its cost. A primary benefit is a free pass on annual compliance tests. Unlike traditional 401(k) plans, safe harbor plans don’t have to pass the IRS’s annual non-discrimination testing or “top-heavy” testing requirements. This “free pass” helps relieve businesses of the financial burden of making hefty refunds or contributions to highly compensated owners and critical executives if the plan fails the testing.

In addition to the 3% minimum safe harbor non-elective contribution required for a safe harbor plan, employers can offer an enhanced match contribution of up to 50% of elective contributions up to 6% of compensation for HCEs or non-highly compensated employees (NHCEs) and a maximum 3% matching contribution for all participants. The enhanced match must be at least as generous as the traditional safe harbor formula and cannot require a 2-year cliff vesting schedule for employer contributions.

Enhanced matching opportunities are also available in the form of an enhanced safe harbor non-elective, which provides a 4% contribution to all participants regardless of deferral levels, rather than the traditional safe harbor match formula of 100% of the first 3% and 50% of next 2% of deferrals. As with the enhanced safe harbor match, the 3% non-elective must be at least as generous as the traditional Safe Harbor formula, and all employer contributions must be immediately vested.