| Should
a 401(k) Plan Be a Safe Harbor 401(k) Plan?
By
Scott M. Feit
MARCH
2007 - A safe harbor 401(k) plan can be an attractive alternative
for companies that might have difficulty satisfying antidiscrimination
testing, or whose owners might be unable to maximize their
contributions due to low employee contributions. If, however,
the majority of employees are contributing to the 401(k) plan,
or if highly compensated employees do not want to maximize
their contributions, then a safe harbor plan may require significantly
higher contributions from an employer than is necessary. Therefore,
a safe harbor 401(k) plan may not be suitable for all employers.
Safe
Harbor 401(k) Plans
Safe
harbor 401(k) plans are very attractive because if the plan
satisfies four conditions, then the 401(k) antidiscrimination
test is deemed satisfied. Then the company’s owners
and other highly paid employees can contribute the maximum
to the 401(k) portion of the plan and not worry about receiving
a refund at the end of the year. The four conditions are—
-
a required contribution,
-
100% vesting for the required contribution,
-
annual notice to all participants, and
-
withdrawal restrictions.
A
safe harbor 401(k) requires that an employer make either
a contribution of 3% of compensation or a matching contribution
(e.g., 100% of deferrals up to 4% of compensation). There
are no accrual requirements for the safe harbor contribution;
therefore, the plan can’t require the participant
to be employed on the last day of the plan year or satisfy
an hours-of-service requirement to receive the safe harbor
contribution. If an employer’s 401(k) plan would have
no difficulty passing the 401(k) antidiscrimination test
and the employer prefers to allocate company contributions
to active participants, then a safe harbor 401(k) plan would
not be in the company’s best interest. The employer
could reduce the amount of the required company contributions
by not having a safe harbor plan.
The
safe harbor 401(k) contribution must be 100% vested immediately.
The plan may still have a vesting schedule for company contributions
other than the safe harbor contribution. A safe harbor plan
is not the solution if an employer’s 401(k) plan can
easily pass the 401(k) antidiscrimination testing and if
the employer, for example, wants participants to work for
a specific number of years before receiving all of the company
contributions. There can be any number of other reasons
not to implement a 401(k) safe harbor plan; an employer
should conduct a careful assessment before deciding.
A
safe harbor 401(k) also requires participants to receive
a notice explaining their rights under the plan. It must
disclose certain information, including which safe harbor
contribution will be made (3% of pay or match) for the year.
The notice must be given on an annual basis within a reasonable
time before the first day of the plan year. The final safe
harbor requirement is the distribution restrictions on the
safe harbor company contributions. For example, safe harbor
employer contributions are not eligible for hardship withdrawal.
The
fundamental question with regard to the establishment of
a 401(k) plan is whether, based on the goals of the employer,
a plan should be a safe harbor plan or a non–safe
harbor plan. Safe harbor 401(k) plans are great for some,
but other employers would do better without them.
Examples
The
following examples will help illustrate whether a safe harbor
401(k) plan is cost effective.
Example
1
| |
Salary |
Deferrals |
401(k)% |
| Owner |
$225,000
|
$15,500
|
6.89% |
| Employee
1 |
50,000
|
0 |
0.00 |
| Employee
2 |
30,000
|
500
|
1.67 |
| Employee
3 |
45,000
|
500
|
1.11 |
In
this example, the average 401(k) percentage for the employees
is 0.93%. Without going into detail of the 401(k) testing
requirements, the employee average would have to be at least
4.89%. This particular plan would fail the 401(k) test.
Generally, the owner would have two choices: Take a refund
from the plan of approximately $11,318, or make a qualified
nonelective contribution (QNEC) to the employees of approximately
$5,000. If the company had a safe harbor match where the
company promised 100% of every dollar deferred up to a maximum
of 4% of pay, then it would cost the employer $1,000 for
the employees ($500 for Employee 2 and $500 for Employee
3). In addition, the owner would be able to receive a safe
harbor match of $9,000 (4% x $225,000). In this example,
a safe harbor plan allows the owner to receive $24,500 [$15,500
401(k), plus $9,000 match] while allocating only $1,000
to the employees.
Example
2
| |
Salary |
Deferrals |
401(k)% |
| Owner |
$225,000
|
$15,500
|
6.89% |
| Employee
1 |
50,000 |
4,000 |
8.00 |
| Employee
2 |
30,000
|
1,000
|
3.33 |
| Employee
3 |
45,000
|
3,000
|
6.67 |
In
this example, the average 401(k) percentage for the employees
is 6%. Again, the employee average would have to be at least
4.89%, so this particular plan would easily pass the 401(k)
test. Therefore, it would be in the best interest of the
owner to establish a 401(k) plan without the safe harbor
feature.
Crucial
Preparation
It
is crucial for a business owner to review a detailed 401(k)
analysis before determining the type of 401(k) to establish.
Many investment companies and third- party recordkeepers
are quick to set up safe harbor 401(k) plans because they
are easier to administer, but a safe harbor plan may not
always be the best choice.
Scott
M. Feit, CPC, QPA, QKA, is a partner
with Abar Pension Services, Inc., an actuarial and recordkeeping
firm in Florham Park, N.J. He can be reached at feit@abarpensioninc.com
or 973-660-2100, ext. 134.
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