There are many types of retirement plans each with their own set of rules, regulations, and, ultimately, reasons why an employer should institute them. That's why we've made it our mission to explain different retirement plans to help employers make the best choice for their company and their employees. This week, we're making port at the safe harbor 401(k).
What is the Safe Harbor?
Before we get into how safe harbor 401(k)s work, we should explain why they came to be. Traditional 401(k) plans are subject to what the IRS calls "nondiscrimination tests," which are designed to ensure that all employees who opted into the plan are benefiting from it—not just the highly compensated employees (HCEs, who earn $125,000 or more per year). The IRS essentially wants to know that owners and HCEs aren't just using their retirement plans as tax havens. See, 401(k) plans are tax-deductible; the government wants businesses to have retirement plans for employees, so they incentivize these plans with tax breaks, but they also want to make sure owners and HCEs aren't getting the tax benefits while leaving non-highly compensated employees (NHCEs) out in the cold.
Safe harbor 401(k) plans automatically pass nondiscrimination tests as long as employers make guaranteed contributions to all their employees.
How do They Work?
There are three options for safe harbor plans. The first is to contribute 3% of every eligible employee's salary—this is called a Non-Elective plan. The second is to provide a 100% match for the first 3% of employee compensation and a 50% match for the next 2%: this is the Basic plan. Finally, in an Enhanced plan, the employer matches 100% of the first 4% of compensation.
As safe harbor plans are still 401(k)s, employees are permitted to make their own contributions to the plan, which also allows them to enjoy the tax breaks of the investment.
Long vesting schedules are not allowed with safe harbor plans as contributions must be fully vested when they are made. Therefore, you must give all employees their share even if they left your company or were fired during the year. Additionally, in order to be effective by January 1, the safe harbor provisions must be established by October 1 of the previous year.
Is a Safe Harbor Plan Right for My Company?
Safe harbor plans are a great choice for companies that plan to match employee contributions anyway, those who worry about passing nondiscrimination and other IRS testing, have low participation among NHCEs, or generally care about the well-being of their employees.
What is the drawback? The biggest downside is the cost of the plan. If, for example, you institute the Non-Elective plan (the 3% compensation match) and every employee participates, then your overall payroll will increase 3% (more if you choose a Basic or Enhanced plan). But to many employers, the benefits outweigh the cost as the plan leads to happier employees, tax savings, peace of mind regarding IRS testing, and more retirement savings for everyone in your organization (even you!).
The clock is running out to convert your existing 401(k) plan into a Safe Harbor for 2020, but there is still time to implement a plan if you currently do not offer this benefit to your employees. For help with that, get in touch!