popularity of the 401(k) plan has made it the most widely used
savings plan in the country. As employers have had to shift limited
resources to cover the ever-increasing cost of other benefits, the
ability for employees to contribute to their retirement savings
helped to ensure the continuation of these plans.
There are numerous regulations that govern 401(k) plans by
encouraging broad based participation and preventing owners and
highly paid employees from receiving disproportionately greater
benefits than other employees. Plans must either satisfy a series of
nondiscrimination tests each year or be designed to satisfy certain
"safe harbor" standards that are predetermined not to be
While the term "safe harbor" is used in many different retirement
plan contexts, it has a very specific meaning when it comes to
401(k) nondiscrimination tests. Before considering the specifics, it
is helpful to have a general understanding of the nondiscrimination
Contributions to a 401(k) plan may include employee salary
deferrals, employer matching contributions and/or profit sharing
(a/k/a nonelective) contributions. Each year, the plan must
demonstrate that contributions for highly compensated employees
(HCEs) are not disproportionately larger than those for non-HCEs
(NHCEs). HCEs are generally owners of more than 5% of the company
and any employee with compensation in the prior plan year over a
specified level ($110,000 for 2009 and 2010).
The actual deferral percentage (ADP) test and the actual
contribution percentage (ACP) test are run after the end of each
plan year. The ADP test compares the average deferral rate for the
HCE group to that of the NHCE group. In most cases, as long as the
HCE average is not more than 2 percentage points greater than the
NHCE average, the test passes. The ACP test works the same way
except that it analyzes employer matching contributions. Consider
Elaine owns a small company and has one employee, Mark, who earns
$150,000 per year. She has eight other employees who all earn under
$100,000 per year. All employees are eligible to participate in the
company's 401(k) plan. Elaine and Mark are considered HCEs, while
the other eight employees are NHCEs. If the average deferral rate
for the NHCEs is 3%, then the average for Elaine and Mark cannot
exceed 5%. If Mark defers 2% of his compensation, Elaine could defer
up to 8% of her compensation and keep their average at or below 5%.
The top heavy determination is another test that is based on the
assets in the plan. If, on the last day of the previous year, the
combined accounts of certain company officers and owners (referred
to as "key employees") exceed 60% of the plan's total assets, the
plan is considered top heavy. Such plans are generally required to
provide a minimum contribution of 3% of compensation for all
eligible non-key employees. This can come as an unwelcome surprise
for employers that had not anticipated or budgeted for contributions
to their retirement plans.
Safe Harbor Plan Eliminates
The primary benefit of the safe harbor 401(k) plan is that the
plan is deemed to automatically satisfy the ADP and ACP tests. This
allows HCEs to defer up to the annual dollar limit ($16,500 for
2010) regardless of how much or how little the NHCEs defer. In
addition, plans that include only employee salary deferrals and safe
harbor contributions (described below) are deemed to satisfy the
top-heavy requirements. As a trade-off, safe harbor plans must meet
a number of requirements including minimum employer contributions,
immediate vesting and participant notices.
Safe Harbor Contributions
The employer can satisfy the contribution requirement by making
either a nonelective contribution or a matching contribution on
behalf of each eligible NHCE. The contribution can, but is not
required to, be made on behalf of HCEs as well.
The nonelective contribution must be at least 3% of compensation
for the plan year for each eligible employee regardless of whether
or not they make salary deferral contributions. Compensation earned
prior to an employee's eligibility date can be ignored. Plans that
allocate profit sharing contributions using a new comparability
(a/k/a cross-tested) formula may prefer the nonelective option,
because the safe harbor contribution may also be used to satisfy
some of the complex testing requirements applicable to such plans.
The matching option requires the employer to match participants'
elective deferrals at the rate of 100% of the first 3% of
compensation deferred, plus 50% of the next 2% of compensation
deferred (maximum match of 4%). The employer can choose to make an
enhanced match, for example, 100% of the first 4% of compensation
deferred, as long as certain guidelines are followed.
Additional matching contributions can also be made, and they will
be exempt from the ACP test, as long as:
- They are not based on deferrals in excess of 6% of
- If they are discretionary, they do not exceed 4% of
How the Plan is Established
Any 401(k) plan can be set up as, or amended to become, a safe
harbor plan. Generally, safe harbor provisions must be in effect for
the entire plan year, although a new plan can be established during
the year as long as it will be in effect for at least three months.
This can be reduced to as little as one month for newly formed
companies with a short initial fiscal year. Existing profit sharing
plans without 401(k) provisions can be amended mid-year to become
safe harbor 401(k) plans, subject to the three-month requirement.
The plan document must specify whether the plan will use the
nonelective or matching contributions formula, and it must address
all other safe harbor requirements described below.
A notice must be provided to eligible employees within a
reasonable period before the beginning of the plan year (or safe
harbor effective date). It will automatically be considered timely
if distributed 30 to 90 days prior to the beginning of the plan
year. For plans that provide for immediate eligibility, new hires
should be provided the notice on their dates of hire.
The notice must contain the basic features of the plan, including
the safe harbor contribution to be provided and rules relating to
elective deferrals, other contributions, withdrawals, vesting, etc.
Some details can be provided by reference to the Summary Plan
Safe harbor plans using the nonelective contribution can be
designed as "maybe" plans. Such a design requires that two notices
be provided to participants. The timing of the first notice is the
same 30 to 90 days described above, and it must inform participants
that the employer might make a safe harbor contribution for the
coming year. The second notice is provided 30 to 90 days before the
end of the year and informs participants whether or not the
contribution will be made. In addition to satisfying this expanded
notice requirement, the "maybe" provisions must be reflected in the
Safe harbor employer contributions must be fully vested and are
not available for in-service distribution prior to age 59½. An
eligible participant cannot be required to work a specified number
of hours or be employed on the last day of the plan year in order to
receive the safe harbor contribution.
Suspension of Contribution
The safe harbor matching contribution can be eliminated during
the year by adopting a formal plan amendment and providing notice to
participants 30 days prior to the effective date. Contributions must
be made through the end of the 30-day period. Plans making this
change lose safe harbor status for the entire year, subjecting them
not only to the ADP/ACP tests but also to the top heavy minimum
contribution requirement which could be more expensive than the safe
harbor match would have been.
As a result of the struggling economy, the IRS issued proposed
regulations in 2009 (which can be relied upon pending final
regulations) that also allow employers to suspend safe harbor
nonelective contributions if they are experiencing a substantial
business hardship. This is determined based upon whether or not:
- The employer is operating at an economic loss;
- There is substantial unemployment or underemployment in the
trade of business and in the industry concerned;
- The sales and profits of the industry concerned are
depressed or declining; and
- It is reasonable to expect that the plan would not continue
unless the contributions are reduced or suspended.
The 30-day notice and testing requirements that apply to the
suspension of safe harbor matching contributions also apply to the
suspension of safe harbor nonelective contributions.
Automatic Enrollment Safe Harbor
A modified version of the safe harbor plan is available for
401(k) plans that contain automatic enrollment features. They
provide that eligible employees will automatically defer a specified
percentage of their compensation into the plan unless they elect not
to participate, and the default deferral rate must generally
escalate each year.
The rules for so-called Qualified Automatic Contribution
Arrangements (QACA) are similar to the regular safe harbor rules,
except that the QACA matching requirement is 100% of the first 1% of
compensation deferred, plus 50% of the next 5% of compensation
deferred (maximum match of 3.5%). In addition, safe harbor
contributions under the QACA must be 100% vested after two years of
service rather than the immediate vesting required of traditional
safe harbor plans. The participant notice must contain additional
information describing the automatic enrollment features.
Eligible Combined Plan
Beginning in 2010, there is a new type of safe harbor plan that
includes the combination of a 401(k) and a defined benefit formula
in the same plan. In order to qualify for this arrangement, the plan
must include an automatic enrollment 401(k) provision, a safe harbor
match or nonelective contribution as well as a minimum defined
benefit. The so-called DB(k) plan is only available for employers
with fewer than 500 employees and is so new that the IRS has not yet
issued regulations describing the mechanics of how the plans are
supposed to operate.
A safe harbor design is an excellent way for many employers to
get the most out of their 401(k) plans. By eliminating ADP/ACP
nondiscrimination testing, all employees can contribute up to the
annual deferral limit and not be concerned about the possibility of
refunds after year-end. Safe harbor contributions may also eliminate
top heavy requirements and can be coordinated with other
contribution allocations. There is much to like about the safe
harbor 401(k) plan.