The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) was signed into law in December 2019. The SECURE Act makes significant changes to the rules for retirement plans to encourage more employers, particularly small employers, to offer retirement savings plans to their employees. Some of the provisions include increased tax incentives, extended deadlines, reduced administrative burdens, and increased fiduciary protections. These law changes are intended to result in more individuals being covered by workplace retirement plans, as well as to encourage individuals to save more for retirement. Many of these changes are effective for plan years beginning January 1, 2020. In the coming months, Benefit Trust will provide details on the changes that will affect 401(k) plans, employers, employees, and retirement plan service providers.
Changes to Safe Harbor 401(k) Plan Rules Allow More Flexibility
The general tax laws require 401(k) plans to pass two nondiscrimination tests each year to make certain that highly compensated employees (HCEs) are not disproportionately benefiting from the plan over the lower paid, rank-and-file employees (non-HCEs):
- Actual Deferral Percentage (ADP) Test – Limits the percentage of compensation HCEs can defer into the 401(k) plan based on the deferral rate of the non-HCEs
- Actual Contribution Percentage (ACP) Test – Ensures that the employer matching contributions and after-tax employee contributions contributed for HCEs are not disproportionately higher than those for non-HCEs
A 401(k) plan will be deemed to satisfy the ADP/ACP requirements if it meets the “safe harbor 401(k) plan” requirements, which include certain elements such as a mandatory employer contribution. Employers may choose to make either a specific matching contribution or a nonelective contribution to meet the requirements to be a safe harbor plan. If a plan is deemed to satisfy the ADP/ACP tests, the HCEs, business owners, and key personnel can save up to the annual deferral limit without worrying about the contribution rates of the lower-paid employees. And, with the guarantee of an employer contribution, more employees may be likely to participate in the plan.
Before the SECURE Act, the choice to become a safe harbor 401(k) plan had to be made prospectively. An employer had to amend an existing plan before the end of the current plan year to add a safe harbor 401(k) feature for the coming plan year and provide a notice to eligible employees at least 30 days prior to the start of the new plan year.
The SECURE Act eliminates the notice requirement for plans that will be providing only a nonelective safe harbor contribution. (The notice is required if a safe harbor matching contribution will be provided).
The SECURE Act also extends the length of time an employer has to decide to become a safe harbor 401(k) plan. Effective for plan years beginning on or after January 1, 2020, an employer may amend a 401(k) plan any time during the current plan year up until the 30th day before the end of the plan year if the employer makes a 3% nonelective safe harbor contribution for that plan year. An employer may wait to amend to become a safe harbor 401(k) plan for the current plan year until the end of the following plan year if a 4% nonelective contribution is made for eligible participants. A 401(k) plan cannot take advantage of this new flexibility if it is already obligated to make a safe harbor matching contribution for the year.
EXAMPLE: According to its mid-year nondiscrimination testing results, the King Tire Company 401(k) plan will likely fail its 2020 plan year-end testing. Henry, the owner of the King Tire Company, knows that his plan would satisfy the nondiscrimination testing if he adopts a safe harbor 401(k) feature and meets the requirements to be a safe harbor 401(k) plan, but he hasn’t made the decision to become a safe harbor plan because is not certain whether his company will have the funds to make the mandatory contribution. With the SECURE Act changes, Henry now has more options.
- He may wait until November 30, 2020, to execute a plan document amendment to become a safe harbor 401(k) plan for 2020 if he provides a 3% nonelective contribution to eligible participants for 2020.
- Alternatively, he could wait all the way up until December 31, 2021, to amend the plan document to adopt the safe harbor feature for the 2020 plan year if he makes a 4% nonelective contribution for eligible participants for the 2020 plan year.
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The safe harbor 401(k) plan design approach can increase plan participation and plan contributions in addition to bypassing ADP/ACP testing. Plan sponsors considering whether a safe harbor 401(k) feature might be a beneficial option for their plan should consult with a financial advisor and their plan recordkeeper about this plan design feature. Safe harbor 401(k) plans tend to be popular with plans that have
- A history of failed ADP/ACP testing,
- Multiple business owners and a small number of lower-paid employees,
- A young or low paid workforce who contribute little to the 401(k) plan, or
- A desire to improve the participation and contribution rates for their employees.