Safe Harbor 401(k) plans are like traditional 401(k) plans, but they offer advantages to businesses at risk of failing the non-discrimination tests. Business owners and highly compensated employees (HCEs) are impacted when they want to make significant contributions to the 401k and the non-highly compensated employees (NHCEs) do not.
Highly compensated employees are generally defined as individuals with more than 5% ownership, family members of a more than 5% owner (spouse, parents, children or grandparents) or employees earning more than $135,000 in the previous calendar year. For example if an employee received $135,000 of compensation in 2022, they would be considered to be a highly compensated employee in 2023. If an employee received $150.000 of compensation in 2023, they would be considered to be a highly compensated employee in 2024.
A Safe Harbor 401k can be beneficial for small business owners who want to max out the salary deferral contributions (2023 limit is $22,500 and $30,000 if age 50 or older), but anticipate the 401k plan will have problems with non-discrimination testing. The safe harbor 401k plan allows owners and highly compensated employees to make the maximum salary deferral contributions to a 401k even if the other employees want to make limited or no contributions to the 401k.
With a Safe Harbor 401k, the business must make contributions to the business owner, to highly compensated employees and to non-highly compensated employees according to one of the following 3 formulas:
- Basic - Match 100% of the first 3% of compensation, plus 50% of the next 2% of compensation.
- Enhanced - Match 100% on the first 4% of compensation.
- Non-Elective - Contribute 3% of compensation to all eligible employees.
Each year the employer must make either the matching contributions or the non-elective contributions. The plan document will specify which contributions will be made and this information must be provided to employees before the beginning of each year.
What are the advantages of a Safe Harbor 401k?
With a Safe Harbor 401k owners and highly compensated employees can contribute the maximum 2023 salary deferral amount ($22,500 and $30,000 if age 50 or older) to a 401k plan regardless of the whether or not the employees contribute to the 401k. Safe Harbor matching contributions are made by the employer to employees and to owners. Safe Harbor 401k plans make it easy for owners to maximize contributions to their own accounts while reducing some of the limitations with complying with the IRS non-discrimination testing rules.
IRS 401(k) rules ensure that 401k plans do not favor Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs). The government has established required compliance tests (ADP, ACP and Top Heavy) to verify all employees have fair representation in a 401k plan. The Safe Harbor 401k plan helps a small business automatically pass the non-discrimination testing by making contributions on behalf of the small business owner and to employees.
What are the non-discrimination tests in a 401(k) plan?
There are three main types of compliance tests required to be performed on a 401(k) plan annually. This compliance testing is required by IRS rules to ensure employees are not being treated unfairly.
- Actual Deferral Percentage (ADP) test compares the deferral percentage of HCEs and NHCEs. Generally, the HCE deferral amount cannot be more than two percentage points higher than the average for the NHCEs.
- Actual Contribution Percentage (ACP) test compares employer matching contributions between the HCEs and NHCEs.
- Top Heavy test determines if the account balances of key employees is greater than 60% of the total assets of the plan.
Safe Harbor 401k plans are deemed to satisfy these non-discrimination tests, so business owners and other highly compensated employees may defer the maximum salary deferral contribution regardless of low participation from non-highly compensated employees.
What are the disadvantages of a Safe Harbor 401k?
The employer is required to make the Safe Harbor contribution to owners and to any other HCEs and NHCEs. As a result Safe harbor 401k plans work particularly well for companies that have consistent revenue and cash flow. Businesses finding it difficult to maintain the required employer contribution year round may find that a traditional 401k plan without a safe harbor match may make more sense.
What is the advantage of a Safe Harbor 401k versus a traditional 401k plan?
A safe harbor 401k plan avoids IRS testing. To avoid non-discrimination testing an employer makes a matching contribution to owners, highly compensated and to employees.
How are owners/partners and the highly compensated employees impacted in a traditional 401k?
All HCEs will be limited to defer only 2% more than the average of all eligible Non-Highly Compensated Employees (NHCEs). Example if the NHCEs contribute an average of 2% of their salary to a traditional 401k than the HCEs can only contribute 4% of their salary to the 401k plan. If NHCEs elect to put in 0% in the 401k plan then with a traditional 401k HCEs would not be able to contribute to a traditional 401k.
Are Safe Harbor 401k contributions made to the employees and to owners a tax deductible business expense?
Yes, contributions made to a safe harbor 401k are generally 100% tax deductible as a business expense.
What is the deadline to setup a Safe Harbor 401k?
Safe harbor 401k plans are required to be set up 3 months prior to the plan year end. For businesses with a December 31 tax year end then the deadline to setup a safe harbor 401k is October 1st.