Safe Harbor 401(k) plans can be a win-win for employers that want to maximize tax savings, bypass certain annual testing requirements, and retain employees through a required employer match.
A safe harbor is like a traditional 401(k) plan, but it is exempt from certain compliance tests as long as other requirements (discussed below) are met. These plans are generally better for companies with a relatively large number of highly compensated employees (“HCE”). Yet, there’s a trade-off. In exchange for the testing exemption, the employer must contribute a certain amount to the plan every year, and those contributions become fully vested when made.
The business owner can contribute the maximum annual deferral amount to their own 401(k) plan ($20,500 for 2022 plus any catch-up contributions), receive additional savings from the company's matching contributions (they're an "employee" too), and, come tax time, the business can deduct all matching contributions (up to the IRS limit).
Safe Harbor plans must be in effect for three months prior to the plan year-end date to be tax-deductible for that tax year and compliant with applicable rules.
Required Employer Match
In non-safe harbor plans, employer contributions are discretionary where the employer decides whether and to what extent to contribute to the plan for any particular year. Employer matches for a Safe Harbor Plan are different. An employer match is required and must consist of the following:
- Non-Elective Contribution: At least 3% of pay for each employee who is eligible for the plan, regardless of whether or not they choose to defer; or
- Safe Harbor Match: At least 100% of each participant's first 3% deferred plus 50% of the next 2% your participants defer. In other words, participants who contribute at least 5% of their compensation to the plan will receive a company match of at least 4% of their pay.
Both of these types of contributions must be immediately vested, and neither can be contingent on any additional conditions, such as working a minimum number of hours or being employed on the last day of the year. It is ultimately your decision which match type to offer. If your goal is to provide a benefit to all eligible employees, the non-elective contribution may be a good fit. If your company is trying to encourage participants to save for themselves, the safe harbor match may be a better option.
You can switch contribution types at some point, but a formal plan amendment is required, and it can only be effective at the start of the next plan year. In other words, once the plan year has started using one type of contribution, it might not be possible to change it until the next plan year. In addition, participants must be notified of the change between 30-90 days before it takes effect.
Safe Harbor Plans with Auto-Enrollment
If your Safe Harbor Plan includes an automatic enrollment feature, there are some additional requirements.
- The automatic deferral rate must start with at least 3% of pay and increase by 1% each year until they reach 6% of pay. After that, escalations each year can continue beyond that up to a maximum of 15% of pay.
- The employer must contribute a match as generous as the Safe Harbor match described above or 100% of the first 1% deferred plus 50% of the next 5% deferred. That’s the equivalent of a match of 3.5% of pay for any participant who defers at least 6% of pay.
- The employer match can vest over two years.
Discretionary Employer Match
If you wish, you can make an additional match beyond the required employer contributions described above. However, before doing so, that match must be included in the plan documents so that participants can adjust their contribution levels accordingly. The discretionary match is also subject to additional compliance testing requirements that may apply; the Vestwell Compliance Team can inform you if that is an issue for your plan. Lastly, unlike the required match, this discretionary match can be subject to a vesting schedule of up to six years, so it can be a very useful employee retention tool.
What Compensation is Used to Calculate the Match?
“Compensation” for purposes of calculating a match is defined in your plan document. When your plan was onboarded to the Vestwell platform, you would have selected how this term is defined. Please refer to your Plan Adoption Agreement in your Vestwell portal and Plan Adoption Agreement Guide that you received during onboarding (a copy is available on our Help Center).
- Newly eligible employees - as employees become eligible throughout the year, your plan document explains whether their company contribution is based on compensation for the entire year (starting January 1) or just from when they joined the plan and forward. Some employers prefer to place everyone on even footing by using full-year pay even if some participants enter the plan later in the year. If your plan document requires using full-year pay, but you only make contributions for a person starting with the date they first become eligible, then year-end adjustments will be required.
- Compensation limits - The IRS limits the amount of compensation that can be considered for any single participant in a given year. For companies that calculate and deposit contributions each pay period, we stop contributions for participants once they hit this compensation cap. If that happens, the company contributions based on pay over that limit must be removed from the affected participants’ accounts.
- Irregular compensation - Most plan sponsors use an employee’s “base” pay for the year as the definition of “compensation.” However, if the plan document says to use gross compensation, then all irregular forms of pay like bonuses and overtime must be factored into the calculation. Of course, it is possible to exclude some or all of these pay types, but doing so triggers additional compliance testing requirements.
- Expenses - Reimbursements are generally not taxable, not reported on Form W2, and are therefore not counted as compensation for purposes of calculating the match. However, allowances are reported on Form W2 as taxable income and must be included when calculating the company contribution to the 401(k) plan.
As you can see from these examples, your plan document is very important, and it is the basis by which we administer your plan. This is why we ask you to read and sign your Adoption Agreement and store it in your portal. One of the best ways to prevent issues from arising is to periodically review your plan documents to make sure you understand them and that they reflect your intent. It’s also important to inform your payroll provider of any changes so that contributions are calculated using the correct “compensation” definition. If you wish to make any changes to your plan features, a formal amendment and notice to your participants are required. The Vestwell Team can assist you.
Deadline to Deposit Employer Match
Your plan documents specify the time period used to calculate the employer match (e.g., annually, per-pay-period, quarterly) which you selected during onboarding. You can see your selections at any time by looking in the Plan Adoption Agreement on your Vestwell portal. If you selected the employer match to be calculated annually, you must deposit the match no later than the last day of the next year in order to comply with the safe harbor rules. If your match is calculated more frequently, you must deposit the contribution no later than the last day of the following quarter. The deposit itself must be made by the due date of your company’s tax return (with any extensions) for the company to take a tax deduction for the match.
Mid-Year Amendment to Remove or Reduce a Safe Harbor Match
Sponsors may need to reduce, suspend, or otherwise change their Safe Harbor plan during the middle of the plan year, for example, when the business is not financially prepared to make the required employer contribution. One of the trade-offs for bypassing some of the annual compliance tests is that the IRS generally does not allow Safe Harbor plans to be amended until the start of the following year. However, due to the COVID-19 pandemic and SECURE Act, the IRS recently gave sponsors more flexibility to make mid-year changes in certain circumstances.
A Safe Harbor plan can be amended to remove a Safe Harbor provision mid-year regardless of whether the plan requires a non-elective match or other types of match. A notice must be given to all participants and employees who are eligible to participate in the plan 30 days prior to the change so that they have sufficient time to stop contributing to the plan or reduce their deferrals, knowing that they will not receive the same match as they would have before the amendment.
If you decide to remove or reduce the Safe Harbor match, there are a few important things to note.
- You are still required to fund the plan from the start of the plan year through the date on which the safe harbor removal becomes effective. You may be able to minimize the impact of the funding requirement by making the actual deposit either at the end of your plan year or when you file your corporate tax return. However, that timing is only for plans with a safe harbor match that is required to be calculated annually. If your plan’s safe harbor match is required to be calculated on some period other than the full year (e.g., per pay-period or quarterly), the deadline to deposit and fully fund the plan is accelerated to the end of the quarter following the quarter in which the match is required.
- If your plan has a per-pay-period match, it may be possible to amend the plan to have an annual match to give additional time to make deposits. However, that amendment must be made retroactive to the start of the plan year, which may result in true-up contributions for any participant who already made deferrals prior to the amendment.
- If your plan is top-heavy, removing the safe harbor provision means the plan becomes subject to the top-heavy rules. Eligible participants employed as of the last day of the plan year will receive an employer contribution of 3% of annual compensation or the highest rate given to a key employee. Since most sponsors that remove safe harbor provisions do so because they cannot afford the safe harbor match, this additional potential contribution may be a critical part of the decision-making process around whether to go forward with removing the safe harbor provision.
- Removing the safe harbor provision will also require the plan to undergo additional compliance testing. One of those tests called the Annual Deferral Percentage test, limits the amount that Highly Compensated Employees can defer into the plan and, if the plan fails, the sponsor may be required to make additional contributions or refunds.
Mid-Year Amendment to Reinstate the Safe Harbor
The SECURE Act allows sponsors to add a safe harbor provision back into the plan when financial circumstances permit. Safe Harbor provisions can be added to the plan in the middle of the year instead of waiting for the next plan year. Suppose a sponsor wants the plan to be treated as a safe harbor plan for the current plan year. In that case, however, the safe harbor provision must be in effect for at least the last three months of the year, which means that a notice of the plan amendment must be provided to participants by approximately September 1 so that the safe harbor provision is in effect for October, November, and December.
Other Administrative Requirements and Limitations
Annual safe harbor notices must be distributed to all eligible employees between 30 and 90 days before the start of each year. Suppose you want to change your plan to add a safe harbor provision for the following year (instead of a mid-year amendment). In that case, we need to know that by November 1 to allow enough time to prepare the amendment and distribute the required participant notice. Lastly, as stated in your Plan Services Agreement, we can assist you with reviewing the feasibility of amending your plan and making any plan amendments. There is a separate fee for those services set forth in Appendix A to your contract.