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.
The Basics
A Safe Harbor 401(k) plan is like a traditional 401(k) plan, but it is deemed to pass certain compliance tests as long as other requirements (discussed below) are met. These plans are generally better for companies that have 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 his/her own 401(k) plan ($22,500 for 2023 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 in order to be tax-deductible for that tax year and compliant with applicable rules.
Required Employer Contributions
In non-safe harbor plans, certain employer contributions can be elected in the plan document to be discretionary, meaning the employer decides whether and to what extent to contribute to the plan for any particular year. In a Safe Harbor plan, however, Employer contributions are required, and must consist of one 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 the first 3% deferred by each participant 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 Safe Harbor type to offer. If your goal is to provide a benefit to all eligible employees, the Safe Harbor 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 has started using one type of Safe Harbor 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 a Qualified Automatic Enrollment Arrangement (QACA)
If your Safe Harbor Plan wishes to adopt a QACA feature, there are some additional requirements. However, a QACA allows the employer to apply a vesting schedule to its contributions, unlike other Safe Harbor contributions which are always 100% vested.
- The automatic deferral rate must start with at least 3% of pay and increase by 1% each year until they reach 6% of pay. Escalations each year can continue beyond that up to a maximum of 15% of pay.
- One of the following Safe Harbor contributions:
- a Safe Harbor match that is either 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.
- a Safe Harbor Nonelective contribution of 3% of compensation to all participants, including those who choose not to contribute to the plan.
- The employer match can vest over two years.
Additional Employer Match
If you wish, you can make an additional match beyond the required Safe Harbor 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 may also be subject to additional compliance testing requirements depending on the amount of that contribution; the Vestwell Retirement Plan Administration Team can inform you if that is an issue for your plan. Lastly, unlike a non-QACA Safe Harbor match, this 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. At the time 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, for plans that use a Third Party Administrator, just from the time 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 he or she first becomes 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. For plans that use a Third Party Administrator, it may be possible to exclude some or all of these types of pay, 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. 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 (eg: 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) in order for the company to take a tax deduction for the match.
Mid-Year Amendment to Remove or Reduce a Safe Harbor Contribution
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 being able to bypass 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 contribution, there are a few important things to note.
- You are still required to fund the plan for the period from the start of the plan year through the date on which the Safe Harbor contribution 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 contribution that is required to be calculated annually. If your plan’s Safe Harbor contribution is required to be calculated on some period other than the full year (eg: 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 contribution is required.
- If your plan elects a per-pay-period determination period, it may be possible to amend the plan to have an annual determination period to give additional time to make deposits. 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 who were 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 contribution, 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 non-elective provision into the plan when financial circumstances permit. Only non-elective Safe Harbor provisions can be added to the plan in the middle of the year instead of having to wait for the next plan year; if you wish to add Safe Harbor matching provisions, you may only do so with an effective date beginning the first day of the next plan year. If a sponsor wants the plan to be treated as a Safe Harbor plan for the current plan year, 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. If you want to change your plan to add a Safe Harbor provision for the following year (as opposed to a mid-year amendment), we need to know that by October 15 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.