As a 401(k) plan sponsor, you have probably received your mid-year nondiscrimination testing results. Did your plan pass? There are no consequences for failing mid-year testing, but it does give you fair warning that your plan may not pass at year-end. If the plan doesn’t pass year-end testing, you will have to take corrective actions such as returning salary deferrals to highly compensated employees (HCEs) or making additional employer contributions for non-HCEs.
If your plan received failing mid-year testing results, and this isn’t the first time, you may want to consider a safe harbor 401(k) plan. This plan design option will ensure your plan passes every year regardless of your employees’ contribution rates.
To take advantage of this approach for the 2020 calendar plan year, you must amend your plan by December 31, 2019, and deliver notices to your employees before December 1, 2019. Read on for more information on what it means to be a safe harbor plan. Then, talk to your financial advisor about whether this plan design feature would be a good fit for your business and your 401(k) plan.
Why Safe Harbor
Unless non-HCEs are actively participating in the 401(k) plan and making substantial contributions, HCEs will be limited as to how much they can save for retirement in the plan. The tax laws require 401(k) plans to pass two nondiscrimination tests each year to make certain that HCEs are not disproportionately benefiting from the plan.
- 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
With the safe harbor plan design approach, the plan is deemed to satisfy the ADP/ACP requirements so long as the plan includes certain elements, such as a mandatory employer contribution. 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 ($19,000, plus $6,000 catch-up if age 50 or older, for 2019) without worrying about the contribution rates of the lower-paid employees. And, with the guarantee of an employer contribution, some non-HCEs may be more likely to participate in the plan. As another benefit, if only safe harbor contributions are made to the plan for the year, the plan is deemed to meet the required top-heavy testing requirements.
The safe harbor 401(k) design feature is 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
- A desire to improve the participation and contribution rates for their employees
Safe Harbor 401(k) Plan Requirements
Talk to your financial advisor, record keeper, or third party administrator about:
- The benefits and limitations associated with safe harbor 401(k) plans,
- Obtaining projections illustrating the potential cost of safe harbor employer contributions and the potential impact on employee savings rates, and
- The cost and timing requirements for amending the plan document and providing participant notices.