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“Safe Harbor” 401(k) Plan Feature - January 2, 2002 (updated January 3, 2005 to reflect final 401(k) regulations)

A 401(k) plan feature is exempt from the special nondiscrimination rules (the ADP and ACP "tests") if it satisfies the 401(k) "Safe Harbor" rules.  To achieve this Safe Harbor status, the plan must satisfy: 1) a contribution requirement; 2) an advance notice requirement; and 3) a 12-month plan year requirement.  View full text of Notice 98-52

This article intends to provide a basic overview of the requirements necessary to achieve Safe Harbor status.  Many additional rules may apply dependent on the individual employer/plan sponsor's facts and circumstances.  See the referenced IRS Notices and the final regulations or contact your pension professional for additional information.

Contribution Requirement  To satisfy the contribution requirement, the employer must comply with one of the following:

  • Contribute a matching contribution on behalf of each nonhighly compensated employee (NHCE) in the amount of 100% of the employee’s elective contributions up to 3% of compensation, and 50% of the employee’s elective contributions on the next 2% (this option can be and typically is expanded to include all eligible employees).  An alternative matching formula will satisfy the Safe Harbor requirement if it is no less than the basic formula described above (e.g., 100% of the employee’s elective contributions up to 4% of compensation); or

  • Contribute a nonelective (profit sharing) contribution for all eligible employees equal to 3% of compensation

Advance Notice Requirement  To satisfy the advance notice requirement, the employer must:

  • Communicate its intention to elect Safe Harbor status at least 30 days (and no more than 90 days) before the beginning of the plan year.  Exceptions to this 30-day advance notice requirement apply in the initial year of a new plan with a 401(k) feature or an existing 401(k) plan first electing Safe Harbor status, and to employees who are first eligible to participate under the plan's 401(k) arrangement as of any subsequent plan entry date that falls within the plan year.  In these instances, the notice may be provided as late as the effective date of the 401(k) feature or the date the participant is first eligible to participate under the plan's 401(k) arrangement.

  • Employers electing the 3% nonelective contribution method have the option to use a "wait and see" notice that permits the employer the option to postpone the Safe Harbor election as long as a second notice stating its final decision is provided 30 days before the plan year-end, and, if so elected, the plan is amended prior to the end of the plan year to provide for the 3% Safe Harbor contribution. 

Commentary  The option to postpone the Safe Harbor is attractive for employer/plan sponsor's that have the potential to satisfy the nondiscrimination tests (the "ADP" and "ACP" tests) for any given plan year absent the Safe Harbor required contribution.  It also eliminates the employer/plan sponsor's contribution requirement in the event of an unanticipated cash crunch.  However, be mindful that if the plan is "Top Heavy," a minimum contribution of up to 3% may still be required, if any "Key" employee has made a 401(k) deferral.  Note that the 3% maximum top heavy contribution is not required to be 100% vested. 

12-Month Plan Year Requirement  A plan does not qualify for Safe Harbor status for a plan year of less than 12 months unless it qualifies under any one of the following exceptions:

  • The short plan year is initial plan year of a new plan (defined as a new plan with a 401(k) feature or an existing plan adding a 401(k) feature during the plan year)This exception applies only if the new plan is in effect for at least 3 months.  View full text of Notice 2000-3

  • The short plan year is created by plan amendment to facilitate a change in the plan year (as provided in the proposed regulations).  This exception applies only if both the previous complete 12-month plan year and the subsequent short plan year satisfy the Safe Harbor rules. 

  • The short plan year is due to plan termination (as provided in the proposed regulations). This is not an all inclusive exemption to the 12-month plan year requirement.  Certain plan terminations may result in the loss of Safe Harbor status, thus requiring conventional testing. 

  • The short plan year is initial plan year of a new plan that is established as soon as administratively feasible after a new employer comes into existence.

Miscellaneous Requirements  In addition to the requirements outlined above, Safe Harbor contributions must be:

  • 100% immediately vested; and

  • Subject to the 401(k) distribution rules (e.g., distribution may not occur prior to specific events or due to hardship)

Benefits for Employer/Plan Sponsors and Plan Participants  Satisfaction of the Safe Harbor requirements provides:

  • Highly compensated employees (HCE) with the certainty that they can contribute the statutory maximum deferral amount absent any limitation or refund resulting from a test failure.

  • The employer/plan sponsor with a plan that is exempt from testing, thus eliminating certain compliance administration requirements.

  • The employer/plan sponsor with a predetermined certainty relative to the maximum cost for employee benefits (i.e., the nonelective contribution provides a finite cost equal to 3% of compensation; the matching contribution provides a maximum cost equal to 4% of compensation assuming all eligible employees contribute 5%; however, the matching approach oftentimes yields an actual cost that is lower than the 3% nonelective option if all eligible employees do not contribute up to5%).

  • NHCEs with a 100% vested employer contribution that is greater than or equal to the recognized industry mean (50% of the employee's elective contributions up to 6% of compensation).

  • A meaningful plan design feature for small business owner plan sponsors that facilitates lower costs for employee benefits, higher benefits for the business owner, and the potential inclusion of a working business owner's spouse in the plan.

View Case Studies that illustrate the benefits of adding a "Safe Harbor" 401(k) feature for a small employer

Commentary  Owners of small businesses (typically with 2-20 employees but oftentimes applicable to much larger employers as well) who have not considered the use of this feature are missing the boat .  We have recommended a "Safe Harbor" 401(k) feature in virtually every existing plan analysis or new plan study performed by our firm on behalf of small employers since this feature was first available in 1999.  "Safe Harbor" provides certainty relative to testing and typically provides a significant increase in benefits for the small business owner and the employees (both the HCEs and the NHCEs).  View Case Study: "Change in Limits Increases Small Business Owner's Share of Pension Pie"

You may ask why this plan design feature typically suggested to benefit the small business owner is also beneficial to the employees.  The obvious answer is that if the owner benefits, the employees do as well, at least to a certain extent.  The less obvious answer is that many of these small employers might not have any plan at all were it not for these "Safe Harbor" options.

A "Safe Harbor" 401(k) feature has many significant benefits but, as with all qualified plan features, this feature comes with a myriad of rules and regulations (both written and operational) that are in a constant state of change, interpretation and finalization.  We, therefore, caution the reader to seek professional guidance prior to implementing any of the ideas discussed herein.

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The information provided is intended as a general resource, not as investment or retirement planning, or legal plan compliance advice or counsel.  If you consider any actions discussed in this update, we suggest that you consult a qualified planning, tax or ERISA professionalMilberg Consulting LLC and Barry R. Milberg do not warrant and are not responsible for any errors and omissions from this update.  Any tax advice included in this written or electronic communication is not intended or written to be used, and it cannot be used, by the taxpayer for the purpose of avoiding any penalties that may be imposed on the taxpayer by any governmental taxing authority or agency.