Scott M. Cloud, MBA, CPC
The Retirement Plan Company
Scott has over 15 years of experience in the retirement plan industry, with expertise in plan design, documents, administration/consulting, and employee education/enrollment.
Including a safe harbor contribution provision in a 401(k) plan enables the employer’s owners and highly-compensated employees (HCEs) to maximize their annual salary deferral contributions. Equally important, by including a safe harbor provision the plan avoids the possibility of corrective taxable refunds that might otherwise result from a compliance testing failure.
Unfortunately, many business owners who start a brand new 401(k) plan choose to do so during the fourth quarter of the year, and – due to a fairly obscure IRS rule – find themselves unable to maximize their 401(k) salary deferral contributions in the 401(k) plan’s initial year. The IRS rule states that if a 401(k) plan is to include a safe harbor provision in its initial plan year, the 401(k) salary deferral provision must be in place for a minimum of three months. For an employer with a calendar fiscal year, this means that eligible employees must be able to make salary deferral contributions starting no later than the first payroll period in October of the plan’s initial year. The October 1 deadline applies whether the safe harbor contribution type is “matching” or “nonelective”.
Missing the October 1 deadline can be costly for business owners. Not only might it mean being unable to maximize salary deferral contributions, but it means that the plan will lack the catalyst – a 3% safe harbor nonelective contribution – that enables some business owners to contribute up to the total annual IRS contribution limit of $56,000. In addition to enabling the business owner(s) to maximize their salary deferral contributions at $19,000, a 3% safe harbor nonelective contribution creates a 3% contribution “base” in nondiscrimination testing (often referred to as “cross-testing”). To get to the $56,000 total contribution maximum, the remaining contributions consist of a discretionary profit sharing allocation that is layered on top of the 3% safe harbor nonelective contribution in cross-testing (and that is significantly skewed in favor of the business owner(s) to take advantage of the age gap between them and younger employees). Remove the safe harbor component from this plan design and maximizing annual contributions at $56,000 becomes cost-prohibitive; often requiring the employer to wait until the next year to start the plan.
Note: Due to the IRS age-50 401(k) catch-up contribution limit of $6,000, the figures of $19,000 and $56,000 in the above paragraph would be replaced with $25,000 and $62,000 for business owners age 50+.
While the IRS deadline for starting a safe harbor 401(k) plan is October 1, setting up a new 401(k) plan can take at least a month. If you or a client are considering setting up a new safe harbor 401(k) plan starting in 2019, it is therefore recommended that the setup of the plan be started no later than mid-August.