Using Safe-Harbor 401(k) Plans

by David M. Roth

Fall 2000

Of the many types of retirement plan options available to employers today, the 401(k) plan is among the most popular. This plan design allows participants to make contributions to the plan from their salaries/wages on a pre-tax basis, and may also provide for employer contributions to "match" the salary deferrals made by participants. Effective last year, Congress added "safe harbor" rules to the law governing 401(k) arrangements. Those new safe harbor rules are making the 401(k) plan design even more popular. The purpose of this article is to discuss the benefits of using the safe harbor 401(k) plan design.

The IRS requires participant salary deferrals and any employer matching contributions to regular 401(k) plans to satisfy certain non-discrimination tests. Those tests are commonly known as the ADP test and the ACP test. When applied, those tests act to limit the extent to which contributions made by highly compensated participants may exceed the average contributions made by non-highly compensated participants. Employers must run the ADP/ACP tests each year, which adds to the administrative costs and complexity of 401(k) plans. To satisfy those tests employers may have to reduce the salary deferrals for highly compensated participants, refund portions of those deferrals, or make additional contributions to plans for non-highly compensated employees.

Safe harbor 401(k) plans are exempt from the ADP/ACP tests. Consequently, highly compensated employees may be able to defer the maximum amounts allowed ($10,500 in 2000) regardless of the level of salary deferrals made by non-highly compensated participants. In addition, the plan's administrative costs decrease and punitive excise taxes are avoided. To obtain those benefits, a safe harbor 401(k) plan must give every participant a 3% nonelective contribution or a matching contribution of at least 4% of compensation, fully vested.

If your current 401(k) plan is considered "top heavy," there are other good reasons to consider the safe harbor alternative. A plan is considered top heavy when the account balances of highly compensated participants exceed 60% of the total assets of the plan. Employers who sponsor top heavy plans are required to make a top heavy minimum contribution equal to 3% of compensation for all participants. When done correctly, that top heavy minimum contribution will also satisfy the nonelective contribution requirement of the safe harbor rules.

To conclude, employers who currently sponsor 401(k) plans but who are frustrated by the ADP/ACP limits will benefit from amending their plans to qualify under the safe harbor rules. Also, by incorporating safe harbor provisions, employers setting up new 401(k) plans can provide highly compensated participants with the maximum salary deferrals possible. All said, the safe harbor 401(k) offers significant benefits to plan sponsors.