A Safe Harbor 401(k) is a type of 401(k) retirement plan that allows small business owners to skirt a specific Internal Revenue Service test. With a Safe Harbor 401(k) plan, the business must make contributions to the business owner, to highly compensated employees (HCEs) and to non-highly compensated employees (NHCEs) according to one of the following 3 formulas:
1. Basic: Match 100% of the first 3% of compensation, plus 50% of the next 2% of compensation.
2. Enhanced: Match 100% on the first 4% of compensation.
3. Non-Elective: Contribute 3% of compensation to all eligible employees.
Each year the employer must make either the matching contributions or the non-elective contributions. The plan document will specify which contributions will be made and this information must be provided to employees before the beginning of each year.
The Advantages of a Safe Harbor 401(k) Plan
IRS rules ensure that 401(k) plans do not favor HCEs over NHCEs. It has established 3 required compliance tests (ADP, ACP and Top Heavy) to verify all employees have fair representation in a 401(k) plan. Therefore, traditionally 401(k) plans must perform the compliance tests each year. If any test fails, the plan must refund excess contributions and the business may face certain penalty.
For a traditional 401(k) plan, all HCEs will be limited to defer only 2% more than the average of all eligible NHCEs. For example, if the NHCEs contribute an average of 3% of their compensation, then the HCEs can only contribute maximum 5% of their compensation to the 401(k) plan. If NHCEs elect to defer 0%, then the HCEs would not be able to contribute to the 401(k) plan.
With a Safe Harbor 401(k) plan, the small business owner and HCEs can contribute the maximum annual deferral amount regardless of whether or not NHCEs contribute to the 401(k) plan or how low the contributions of NHCEs. In addition, the business is exempt from the annual compliance tests mentioned above.
The Disadvantages of a Safe Harbor 401(k) Plan
The small business owner is required to make the Safe Harbor contributions to themselves and to all other HCEs and NHCEs. As a result, Safe Harbor 401(k) plans work well for companies that have consistent good revenue and cash flow. For businesses that have financial difficulties or cash flow problems, it is very hard to maintain the required employer contribution year round. In this case, a traditional 401(k) plan without a Safe Harbor feature is more suitable.
Setting up a Safe Harbor 401(k) Plan
Safe Harbor 401(k) plans tend to be more suitable for companies with predictable revenue streams. If a business has difficulty finding matching funds on a consistent basis then other 401(k) plans may be a better alternative to the Safe Harbor 401(k).
Safe Harbor 401(k) plans are required to be set up at least 3 months prior to the plan year-end. For a plan with a December 31 year-end, the deadline to set up a Safe Harbor 401(k) is September 30th.
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