OVERVIEW OF PLAN TYPES

An employer who decides to sponsor a retirement plan for its employees is faced with countless choices. Certain plans represent administrative ease. Other plans come with more favorable tax incentives. Still other plans provide flexibility. An employer can pick the funding arrangement, as to whether the employer or the employee or both will contribute to the retirement plan. Selecting the right plan is important, because it impacts the benefits received, the cost of operation, the employer's tax liability, perception by employees, and, ultimately, overall company profitability.

401(k) SAFE HARBOR PLANS

The term “401(k) plan” merely refers to a type of funding arrangement that is part of a profit sharing, stock bonus or pre-1974 money purchase pension plan. A 401(k) arrangement allows employees to defer a portion of their current compensation into a tax-qualified plan to accumulate tax-free, and to be taxed only when the funds are later distributed. Operationally, many plans have to undergo the vexing problem of failed annual nondiscrimination ADP/ACP testing and the resultant chaos, namely, additional contributions to non-highly compensated employees, or refunds & amended individual tax returns for highly compensated employees.The Internal Revenue Service has provided an approach for plans to meet an exemption from these nondiscrimination rules provided the two requirements regarding notices and contributions are met:

  1. Notice Requirements: For an existing plan, notice must generally be provided to eligible employees 30 to 90 days before the beginning of the plan year; or 30 days before the end of the plan year, if notice was provided before the beginning of the plan year that the employer may use the safe harbor option. A new or converted 401(k) plan, including a plan that adds the 401(k) feature, may give notice up to the effective date of the plan, as long as at least three months remain in the plan year. A safe harbor 401(k) plan sponsored by a new business entity may have an initial plan year as short as one month.
  2. Contribution Requirements: One of the following two fully vested minimum contribution requirements must be met:
    1. (a) an employer non-elective contribution of 3% of pay to all eligible employees, regardless of active participation; or
    2. (b) matching contributions of 100% of the first 3% of compensation deferred, and 50% of the next 2%.

    The basic safe harbor matching formula results in a contribution of 4% of compensation to employees who defer 5% of compensation or more.

It is possible to contribute more, but not less, than the basic contribution requirements: either as an enhancement of the basic formula, and/or as an additional fixed contribution specified in the plan document, and/or as an additional discretionary contribution limited to 4% of compensation.

ADVANTAGES

  • Highly compensated employees of the employer can contribute their maximum allowable deferral under the Internal Revenue Code
  • Highly compensated employees are not saddled with refunds at the end of the year, and the associated need to amend their individual tax returns
  • Within certain guidelines, a safe harbor 401(k) plan is exempt from top-heavy requirements (please refer to the “Analysis” section below for more information)
  • The employees’ benefits and the employer’s contribution liability can be estimated ahead of time
  • The safe harbor arrangement greatly cuts down administrative hassle
  • Safe harbor contributions can be used to offset profit sharing contributions, especially in plans that provide tiered (new comparability) allocation formulas
  • A certain amount of flexibility can be built in to the design of a safe harbor 401(k) plan. However, if the plan does not provide safe harbor contributions for the entire plan year, it may become subject to nondiscrimination testing for the entire year
  • Tax-exempt organizations, churches, and Indian tribal governments may also adopt a 401(k) plan
  • Safe harbor non-elective contributions may be made to another defined contribution plan of the employer

POSSIBLE DISADVANTAGES

  • Safe harbor contributions are required to be fully vested. This is a disadvantage for the employer, not the employee
  • Employer safe harbor contributions are not accessible to in-service withdrawals prior to attainment of age 59 1/2 even for financial hardships
  • A plan may not impose a “last day employment” or hour of service accrual requirement with respect to safe harbor contributions
  • Safe harbor contributions may not be used in conjunction with any form of permitted disparity (use an allocation formula that makes adjustments for Social Security benefits)
  • Safe harbor contributions may not be made to a defined benefit pension plan sponsored by the employer

ANALYSIS

A safe harbor 401(k) plan needs to be designed with careful consideration, because the top-heavy exemption introduced by EGTRRA applies on a year-by-year basis, so that a plan may satisfy the exemption in one plan year and not in another. The top-heavy exemption does not apply in years the employer allocates profit sharing contributions (or forfeitures as profit sharing contributions) in addition to safe harbor contributions. It also does not apply in plans that have multiple eligibility requirements, which result in not all employees eligible to make 401(k) deferrals receiving safe harbor contributions. A safe harbor 401(k) plan using the 3% safe harbor non-elective contribution formula, and to which the employer makes tiered profit sharing contributions is not exempted from top-heavy rules. However, such a plan can be designed to meet the top-heavy requirements automatically, as long as care is taken in drafting the document provisions pertaining to employee eligibility and compensation definition.

EXAMPLES(S)

– FOR ILLUSTRATION PURPOSES ONLY
  1. Example of basic 3% safe harbor non-elective contribution or basic matching contribution:
    Age Comp. Deferrals SH NEC OR SH Match
    HCE1 60 $245,000 $22,000 $7,350 $9,800
    HCE2 50 $150,000 $22,000 $4,500 $6,000
    Total $395,000 $44,000 $11,850 $15,800
    NHCE1 21 $30,000 $0 $900 $0
    NHCE2 25 $40,000 $1,000 $1,200 $1,000
    NHCE3 60 $50,000 $4,000 $1,500 $2,000
    NHCE4 45 $60,000 $0 $1,800 $0
    NHCE5 50 $70,000 $2,450 $2,100 $2,275
    Total $250,000 $7,450 $7,500 $5,275
    Grand Total $645,000 $51,450 $19,350 $21,075
  2. Example of 3% safe harbor non-elective contribution used in conjunction with tiered profit sharing contributions:
    Age Comp. Deferrals SH NEC Profit Sharing Total
    HCE1 60 $245,000 $22,000 $7,350 $25,150 $54,500
    NHCE1 21 $30,000 $0 $900 $600 $1,500
    NHCE2 25 $40,000 $0 $1,200 $800 $2,000
    NHCE3 60 $50,000 $0 $1,500 $1,000 $2,500
    NHCE4 45 $60,000 $0 $1,800 $1,200 $3,000
    Total $180,000 $0 $5,400 $3,600 $9,000
    Grand Total $425,000 $22,000 $12,750 $28,750 $63,500

CONCLUSION

Safe harbor 401(k) plans offer tremendous value to employers who hate surprises, wish to reduce administrative burden, and want to maximize benefits to highly paid employees and owners. Several creative formulas and options are available to meet the goals of various employers. Employers such as professional firms of physicians, attorneys, and architects, who have a far greater number of highly compensated employees than non-highly compensated employees, will find this arrangement attractive, as will employers who customarily make a discretionary contribution.