Editorial · September 24, 2024
Safe Harbor 401(k): How Small Employers Skip Testing
A safe harbor 401(k) is a plan design that lets an employer skip the yearly tests that check whether a 401(k) favors higher-paid staff. In return, the employer must make set contributions for workers and give them a notice. For many small firms, that trade is worth it.
What a safe harbor 401(k) is
A safe harbor plan looks a lot like a regular 401(k). Workers choose how much of their pay to defer, and the money is invested. The difference is the employer promise. The employer must put in money that the worker owns right away, with no waiting period to earn it.
The IRS says a safe harbor plan "is not subject to the complex annual nondiscrimination tests" that apply to a traditional 401(k). That is the main reason owners pick one.
Why testing matters
A traditional 401(k) must show that it does not favor highly compensated employees. For 2024, the IRS generally treats a worker who earned $155,000 or more from the employer in the prior year as highly compensated. A plan can meet the rule in two ways. It can pass the Actual Deferral Percentage and Actual Contribution Percentage tests, or it can use safe harbor contributions.
If a plan fails the tests, the owner may have to return money to higher-paid staff or add contributions. A small firm with a few high earners and a few workers who save little can fail often. A safe harbor design removes that risk.
The two contribution choices
The IRS describes two main ways to meet the safe harbor rules. An employer must make one of them every year.
- Matching contribution. The employer matches each worker's deferral dollar for dollar up to 3 percent of pay. It then adds 50 cents on the dollar for deferrals above 3 percent, up to 5 percent of pay.
- Nonelective contribution. The employer puts in 3 percent of pay for every eligible worker. This is paid whether or not the worker defers anything.
The match costs less if few workers sign up. The 3 percent option costs the same no matter how many save, but it is simple, and it helps workers who cannot defer yet.
Either way, the money is fully vested when made. A worker who leaves keeps all of it. In a traditional plan, an employer can use a vesting schedule instead.
The notice and the deadlines
Most safe harbor plans must give each eligible employee a written notice. It explains the safe harbor method, how to make or change a deferral election and which other plans are involved. The employer can send it by electronic means.
The IRS treats the notice as on time if workers get it at least 30 days and no more than 90 days before the plan year starts. Special rules cover workers who become eligible after the 90th day. For plan years beginning after December 31, 2019, a plan that uses the nonelective contribution no longer needs this notice, though workers must still get a yearly chance to change their election.
Timing matters when a plan switches. An employer may adopt a safe harbor plan with nonelective contributions before the 30th day before the plan year ends. If the employer pays 4 percent instead of 3 percent, the change may be made any time before the last day of the following plan year.
Limits that still apply
A safe harbor plan is still a 401(k). For 2024, an employee can defer up to $23,000. Workers age 50 and over can add a catch-up amount of $7,500. Total limits on all contributions also apply. The plan can be used by employers of any size and can be combined with other retirement plans.
An employer that provides no extra contributions beyond the safe harbor ones is also exempt from the top-heavy rules in section 416 of the tax code.
A short checklist for owners
- Pick the match or the 3 percent nonelective contribution, and price it for a full year.
- Write the plan terms down and have the notice ready 30 to 90 days before the plan year.
- Make sure payroll can fund the contribution every pay period or on schedule.
- Talk with a plan provider or tax adviser before you adopt or switch, because your facts may change the answer.
This article is general information and not tax or legal advice.
Sources
- IRS, 401(k) Plan Overview, irs.gov/retirement-plans/plan-sponsor/401k-plan-overview
- IRS, 401(k) Plan Qualification Requirements, irs.gov/retirement-plans/plan-sponsor/401k-plan-qualification-requirements
- IRS, Operating a 401(k) Plan, irs.gov/retirement-plans/operating-a-401k-plan
- IRS, Mid-year changes to safe harbor 401(k) plans and notices, irs.gov/retirement-plans/mid-year-changes-to-safe-harbor-401k-plans-and-notices