Safe Harbor 401(k) Plans: How They Work and When They Make Sense

Many small business owners learn about nondiscrimination testing the hard way. They contribute the maximum to their own 401(k) all year, and then, after the plan year ends, they are told part of their contributions must be refunded because the plan failed its annual test.

A safe harbor plan design is a common way to avoid that outcome.

The testing problem

Each year, a traditional 401(k) must pass nondiscrimination tests that compare how much highly compensated employees (HCEs) save with how much everyone else saves.

• The ADP test compares average deferral rates.
• The ACP test compares average matching and after-tax contribution rates.

If HCEs, often the owners and their families, save at much higher rates than other employees, the plan fails. The usual fix is refunding some HCE contributions, which become taxable, or making additional employer contributions for other employees.

Small businesses fail these tests often, simply because owners tend to save heavily while some employees save little or nothing.

How safe harbor works

In a safe harbor plan, the employer commits to making a required contribution for eligible employees. Traditional safe harbor contributions must be fully vested immediately. In exchange, the plan is treated as passing the ADP test, and the ACP test for matching contributions that meet the requirements.

If a plan's only contributions are employee deferrals and safe harbor contributions, it is also generally exempt from top-heavy rules, which is another common issue for small plans.

Contribution options

There are several ways to meet the safe harbor requirement.

Basic safe harbor match. 100% of the first 3% of pay an employee defers, plus 50% of the next 2%. An employee deferring 5% or more receives a 4% match.

Enhanced safe harbor match. Any formula at least as generous as the basic match at every level of deferral. A common example is 100% of the first 4% of pay deferred.

Safe harbor nonelective contribution. At least 3% of pay for every eligible employee, whether or not they defer.

QACA safe harbor. Plans that use automatic enrollment can adopt a qualified automatic contribution arrangement, with a match of 100% of the first 1% deferred plus 50% of the next 5%, or a 3% nonelective contribution. QACA contributions can be subject to vesting of up to two years.

Match or nonelective?

Each approach has tradeoffs.

A safe harbor match costs more when more employees participate and less when fewer do. Employees who do not defer receive nothing.

A nonelective contribution goes to every eligible employee, so the cost is predictable. On a $50,000 salary, a 3% nonelective contribution is $1,500. It also counts toward the top-heavy minimum and can be paired with a profit sharing contribution in plans designed to direct more of the employer's total contribution to owners and key employees, subject to testing.

The better fit depends on your budget, your participation rates, and your goals for owner contributions.

Deadlines and flexibility

Timing rules differ by type.

• Safe harbor match. Generally must be in place before the plan year begins, with an annual notice provided to employees 30 to 90 days before the start of the plan year.
• Safe harbor nonelective. The SECURE Act of 2019 removed the annual notice requirement for nonelective safe harbor plans and added flexibility for mid-year adoption. A plan can be amended to add a 3% nonelective safe harbor up to 30 days before the end of the plan year, or adopt a 4% nonelective contribution later, up to the end of the following plan year.

Suspending or reducing safe harbor contributions mid-year is possible only under specific conditions and with advance notice to employees.

Who safe harbor fits

A safe harbor design may be a good fit when:

• Owners or other HCEs want to contribute the maximum each year
• The plan has failed ADP or ACP testing in the past
• The plan is top-heavy or likely to become top-heavy
• The business can commit to a predictable annual contribution

It may be a weaker fit for businesses with very tight budgets or those that rely on a long vesting schedule to manage the cost of turnover, though the QACA option allows limited vesting.

Pairing safe harbor with profit sharing

Many owner-focused plans combine a safe harbor nonelective contribution with a separate profit sharing contribution. With the right design and testing, this approach can let owners reach higher total contribution levels while meeting nondiscrimination requirements. These designs require careful work with a third-party administrator.

Want a second look at whether safe harbor fits your plan? Brian Williams, CPFA®, of Northshire Consulting LLC | Registered Investment Advisory Firm meets with business owners to review plan design. Call 203-401-6062, email bwilliams@northshireconsulting.com, or visit northshireconsulting.com to schedule a plan review.

Frequently asked questions

Can we add a safe harbor provision to our existing plan?

Yes, subject to timing rules. Safe harbor matching contributions generally must be in place before the plan year begins, while nonelective contributions can be added later in the year under the SECURE Act rules.

Do safe harbor contributions have to be vested immediately?

Traditional safe harbor contributions do. QACA safe harbor contributions can be subject to vesting of up to two years.

Does safe harbor eliminate all testing?

No. It addresses the ADP test and, for qualifying matches, the ACP test. Coverage testing still applies, and the top-heavy exemption is lost if the plan makes other employer contributions such as profit sharing.

This material is for educational purposes only and is not individualized investment, tax, or legal advice. Advisory services are offered through Northshire Consulting LLC | Registered Investment Advisory Firm.