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The time to consider using a safe-harbor 401(k)
plan design is upon us again. Now that we have a GUST plan document
that includes 401(k) safe-harbor provisions, we need to remember that
the plan document rules require that the safe-harbor provisions must
be incorporated into the document for the safe-harbor plan to become
operative. Conversely, if the plan has already incorporated the
safe-harbor provisions into the document but as of the 2004 plan year
is not going to be a safe-harbor 401(k) plan, the safe-harbor
provisions must be removed from the plan document by a plan amendment
to avoid a situation in which the plan is not operating in accordance
with the terms of the plan document.
Safe-harbor 401(k) plans offer many advantages that some employers
will gladly embrace. For other employers, the cost involved may be
prohibitive. Either way, an understanding of the rules makes an
informed decision possible.
General Rules for all Safe-Harbor Contributions
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All safe-harbor contributions are 100% vested. |
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There may be no allocation requirements imposed on safe-harbor
contributions, such as, a 1,000-hour service requirement or a last
day employment rule. |
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Safe-harbor contributions are not available for in-service
withdrawal prior to age 59˝.
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Safe-harbor contributions may not be used to satisfy permitted
disparity (social security integration) allocation formulas. |
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Safe-harbor contributions may be used towards satisfying the
top-heavy plan minimum contribution requirement.
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All eligible participants must receive a written notice describing
the applicable safe-harbor provisions between 30 and 90 days
before the beginning of the plan year. This notice must be
provided for each year the plan will be safe-harbored. |
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Why a Safe-Harbor 401(k) May Work for You
Adopting a safe-harbor 401(k) plan design permits an employer to avoid
discrimination testing of the rates of employee elective deferrals
and/or employer matching contributions (ADP/ACP testing). The price
for avoiding testing is a safe-harbor contribution. Generally, there
are two types of safe-harbor contributions.
The Nonelective Contribution – Guaranteed or Flexible Option
One type is the safe-harbor Nonelective Contribution (NEC) of 3% or
more of compensation (commonly known as the “3% NEC”). Generally, the
3% NEC must be provided to all employees eligible to make elective
deferrals to the plan. The NEC may be either a guaranteed contribution
or a flexible contribution. The employer selects which type of
contribution in the plan document. The guaranteed contribution
requires that a NEC be made each plan year, unless the employer amends
the plan and removes the provision before the start of the new plan
year. The flexible NEC allows the employer to decide each year whether
to provide a NEC contribution. If this option is selected, the
employer provides a “conditional notice” 30 to 90 days before the
start of the plan year in which the employer states that it may give a
safe-harbor NEC contribution for that year. No later than the first
day of the 12th month of the plan year, the employer must provide
another notice indicating that the safe-harbor has been elected and
that the NEC is being given. If the NEC is made, discrimination
testing of elective deferrals is not required; if the NEC is not
given, elective deferral contributions must be tested.
The Matching Contribution – Basic or Enhanced Match Formula
The other type of safe-harbor contribution is a matching contribution.
There are two options from which to choose, the basic or the enhanced
match.
The basic safe-harbor matching contribution is defined as a 100% match
on the first 3% deferred and a 50% match on deferrals between 3% and
5%.
Alternatively, the employer may choose an enhanced matching formula
equal to at least the amount of the basic match; for example, 100% of
the first 4% deferred. The enhanced matching contribution rate may not
increase as the percentage of deferrals goes up, and the rate of match
for the highly compensated employee group (HCEs) may not exceed the
rate of match for the nonhighly compensated employee group (NHCEs).
The type of safe-harbor contribution selected must be described in the
annual notice to eligible participants.
Thus, implementing a safe-harbor design can be critically important
for HCEs if the plan has been having trouble passing the ADP/ACP
test. This is because making a safe-harbor contribution permits the
plan to satisfy ADP/ACP testing requirements, and the HCEs may make
the maximum elective deferral to the plan, including a catch-up
contribution (if eligible). In 2004, the maximum 401(k) deferral is
$13,000. In addition, if the participant is over age 50, or will
attain age 50 during 2004, a catch-up contribution of $3,000 may also
be made.
Safe-Harbor Plans May Make Additional Matching Contributions
A safe-harbor plan may make additional matching contributions without
falling out of safe-harbor status. However, if the additional matching
contribution is discretionary, the contribution may not exceed 4% of
compensation. Further, matching contributions may not be made on more
than 6% of compensation. The rate of match for any HCE may not be
more than that of any NHCE.
Top-Heavy Plans Can Get Twice the Bang for the Buck.
If the plan is top heavy, the employer can get twice the mileage out
of its safe-harbor contribution. There are three ways this can happen.
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When a 3%
NEC is made to a top-heavy plan, the 3% NEC generally satisfies
the top-heavy contribution requirement. |
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If the plan is
making a safe-harbor match and the plan is top heavy, the match
counts towards satisfying the top-heavy minimum contribution for
those employees who receive it. For example, if a participant
defers 2% and receives a 2% match, when the employer makes the top
heavy contribution, that employee would only have to receive 1%
more to satisfy the 3% top-heavy contribution requirement. |
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A plan that only permits elective deferrals and
contributions that satisfy the ADP and ACP safe harbor provisions
is exempt from the top-heavy rules. To be exempt, there cannot be
any other employer contribution (i.e., profit sharing
contribution) and forfeitures cannot be allocated on a basis other
than as a match that satisfies the ACP safe harbor. To further
clarify, discretionary matching contributions that do not trigger
the ACP test (as described above) may also be made. |
Cross-Tested Plans
For those employers who have a new comparability plan and who are
using the 5% gateway, the 3% NEC safe-harbor contribution can perform
as the first 3% towards the 5%. In addition, as stated above, if the
plan is top-heavy, the 3% NEC can serve as the top-heavy contribution
as well as towards the new comparability gateway while also providing
the safe-harbor.
NOTE: In a safe-harbor 401(k), if a participant leaves before the end
of the plan year and is not eligible for the cross-tested allocation
due to a last-day rule, the participant must be given a safe-harbor
401(k) 3% nonelective contribution. Assuming the plan uses the 5%
gateway, the participant must receive an additional 2% contribution to
satisfy the gateway. This is because the minimum gateway allocation
must be made to any nonhighly compensated employee who has received
any allocation of employer contributions.
Keep in mind that if the 3 times gateway design is used, the minimum
gateway contribution will still have to be met. However, a safe-harbor
3% NEC may be sufficient to meet the gateway if the allocation to HCEs
does not exceed 9%.
Establishing A Safe-Harbor 401(k) Plan
Existing 401(k) Plan
Safe-harbor 401(k) plan provisions may not be added to an existing
401(k) plan in the middle of a plan year. Instead, the plan must be
timely amended to add the safe-harbor 401(k) provisions for the next
plan year. It is critical that the amendment should be adopted not
later than the last day of the current plan year to ensure that the
safe-harbor notice to participants is provided not less than 30 days
before the first day of the following plan year. If the deadline to
amend the plan is missed, then the plan cannot be safe-harbored and
you will have to wait until the following plan year to adopt a
safe-harbor design.
New 401(k) Plan
In an exception to the timing requirements for giving the safe-harbor
notice, a new 401(k) may adopt a safe-harbor design at the same time
that the plan is established, assuming the notice is provided
simultaneously. There must be at least 3 months remaining in the plan
year to make elective deferrals for a plan to use this provision. An
existing profit-sharing plan that is amended to add a 401(k) feature
is eligible to use this rule. Further, a totally new business entity
establishing a new 401(k) plan may have as short as a one-month
initial plan year (assuming that the initial year is then followed by
the normal 12 month year).
Can Safe-Harbor be Stopped During a Plan Year in the Event of
Financial Setbacks?
The sponsor of a plan using a guaranteed 3% NEC must make that
contribution regardless of its subsequent financial condition during
that plan year. However, an employer may stop making safe-harbor
matching contributions by providing a notice to the employees. This
notice must be given at least 30 days before the contributions are to
be stopped. If an employer stops safe-harbor matching contributions
before the plan year is completed, the ADP and ACP tests must be
preformed for the entire plan year.
Testing Otherwise Excludable Employees
A safe-harbor 401(k) plan which has an eligibility of 1 year of
service and age 21 for the safe-harbor matching contribution or the
safe-harbor nonelective contribution and yet permits entry into the
plan for elective deferrals without the 1 year of service and age 21
statutory requirements, must test those who have not met the statutory
requirements separately from those who have achieved the statutory
requirements. For a safe-harbor 401(k) plan, the nonstatutory group to
be tested would include both the HCEs and NHCEs. Therefore, the HCEs
in the under age 21 and /or under 1 year of service group would be
limited by the ADP/ACP or the NHCEs in the nonstatutory group. Why?
Since there is no safe-harbor contribution made for participants
making elective deferrals who have not satisfied the 1 year and age 21
requirements; testing must be done for the nonstatutory group if there
are any HCEs in the nonstatutory group. |
