By: Scott M. Cloud, MBA,CPC
A well-designed 401(k) plan can help to recruit and retain employees, and – for most workers who have access to a company 401(k) plan – it serves as the primary (or only) investment vehicle to accumulate savings for retirement. For most employers, the 401(k) plan’s effectiveness in helping owners and key personnel to save meaningful amounts for retirement is limited by annual compliance testing required by the IRS. In this article, we describe those compliance testing requirements and explain how a safe harbor contribution provision offers several advantages in exempting the plan from those testing requirements.
The Actual Deferral Percentage (ADP) Test
What is the ADP test and how does it work?
The actual deferral percentage (ADP) test exists to help ensure that non-highly compensated employees (NHCEs) can make 401(k) contributions at near the same rate as the employer’s highly compensated employees (HCEs). HCE and NHCE are defined by the IRS.
An HCE is anyone who:
1) owns more than 5% of the business,
2) is related to a 5%+ owner as a spouse, child, parent, or grandparent, and/or
3) had gross wages from the employer of $135,000+ in the prior year.
Everyone else is an NHCE.
Each year the plan is required to calculate the average 401(k) contribution percentages for both the HCE and NHCE groups. For example, if there are three HCEs who contribute 3%, 7%, and 8%, the HCE group’s “average deferral percentage” would be (3%+7%+8%) / 3 HCEs = 6%. Once the average deferral percentage is calculated for the NHCE group, the HCE and NHCE groups’ averages are compared. If the HCE group’s average doesn’t exceed the NHCE group’s average by more than 2%, testing passes and no corrective action is required. If the HCE group’s average exceeds the NHCE group’s average by more than 2%, testing fails and the plan is required to make “corrective taxable refunds” to the HCE(s) who contributed the most to bring the HCE group’s average down to the 2% threshold required to pass testing. The purpose of corrective taxable refunds is to remove the excess HCE 401(k) contributions from the plan and treat them as if they had not been contributed to the plan in the first place. If the testing sounds complex, don’t worry: testing is performed by the plan’s third-party administrator (TPA), who communicates the results – and any required corrective action – to the employer.
What happens if a 401(k) plan fails an ADP Test?
ADP test failures are common and can make for unhappy HCEs when they’re told they’ll be receiving a corrective taxable refund. For plans that are subject to the ADP test each year, it is generally recommended that the employer be proactive in limiting or eliminating the possibility of an ADP testing failure. This is accomplished by estimating the NHCE group’s average deferral percentage and then communicating to all of the HCEs that they are only able to make 401(k) contributions up to the NHCE group’s average plus 2%. Unfortunately, this can still make for unhappy HCEs who would like to make 401(k) contributions up to the annual IRS limit of $20,500 (plus an additional $6,500 “catch-up” contribution for those age 50+). Note: this limit applies in 2022 and is indexed for cost-of-living adjustments.
A Safe Harbor Contribution Provision
Fortunately, the IRS offers employers a way to give the plan a complete exemption to the ADP test, thereby enabling HCEs to make 401(k) contributions up to the annual IRS limit without the possibility of an ADP testing failure resulting in corrective taxable refunds. To gain an exemption to the ADP test, the employer can make one of two types of safe harbor contributions: a 3% safe harbor “nonelective” contribution or a 4% safe harbor “matching” contribution.
What are the employer’s different options for making a safe harbor contribution?
Option 1 – Safe Harbor 3% Nonelective
“Nonelective” means “not conditioned on employees making 401(k) contributions”. The safe harbor nonelective contribution is made on 3% of gross wages to all eligible plan participants whether or not they make 401(k) contributions.
Option 2 – Safe Harbor 4% Matching
The 4% safe harbor matching contribution is a “company match”, which is conditioned on employees making 401(k) contributions. The “basic” (i.e., minimum required) IRS safe harbor matching contribution formula is a 100% match on the first 3% of 401(k) contributions and a 50% match on the next 2% of 401(k) contributions, for a maximum matching contribution of 4%. If this sounds too complicated, you’re not alone. The IRS permits the plan to use an “enhanced” safe harbor matching contribution formula as long as that formula is at least as favorable as the IRS “basic” formula at all 401(k) contribution levels. Many employers prefer a safe harbor matching contribution formula of 100% on the first 4% of 401(k) contributions because it is generally easier for employees to understand and it is easier to calculate and fund to the plan.
The type of safe harbor contribution is determined by the employer. There is no requirement that one option be used versus the other. Regardless of the type of safe harbor contribution that is made, the employer is given the option to fund the contribution to employee accounts each payroll period throughout the year, or in a single lump-sum deposit after the end of the year. If the latter is selected, the contribution must be funded by the employer’s tax filing deadline – including extensions – to be tax-deductible to the employer for the year of the contribution.
Which employees must receive the safe harbor contribution?
HCEs are usually included in the safe harbor contribution allocation, but they don’t have to be. The IRS permits the employer to exclude HCEs from the safe harbor allocation and still gain an exemption to the ADP test. Excluding HCEs from the safe harbor contribution is most commonly done by employers who want HCEs to be able to contribute 401(k) up to the annual IRS maximum, but don’t have it in the company budget to fund a safe harbor contribution to the HCE group.
What other requirements apply to the safe harbor contribution?
The safe harbor contribution is a “fixed” contribution that is written into the plan document and represents a commitment to employees. By adding a safe harbor contribution provision to a 401(k) plan, the employer obligates itself to make the safe harbor contribution for the full 12-month plan year. A safe harbor contribution provision can be removed with a plan amendment, but – with few exceptions – this can only be done as of the beginning of the next plan year.
A couple of other requirements apply to safe harbor contributions that do not apply to more traditional “discretionary” matching and profit-sharing contributions. First, safe harbor contributions are required to be 100% vested and cannot be subject to a vesting schedule. Second, safe harbor contributions cannot be subject to “allocation conditions” whereby an employee is only eligible for an employer contribution if they are employed as of the last day of the plan year and/or worked at least 1,000 hours with the employer during the year. The safe harbor contribution is made to all employees who were eligible for the plan at any time during the year.
In a safe harbor 401(k) plan that makes a 4% matching contribution, at least 30 (but no more than 90) days before the beginning of each plan year the employer is required to distribute a “safe harbor notice” to employees notifying employees of the safe harbor matching contribution that will be made for the upcoming year. The notice is required in order to give employees time to consider what 401(k) contributions they would like to make for the coming plan year in light of the fact that the safe harbor matching contribution will be made. (Note that this annual notice requirement does not apply to plans that make the safe harbor 3% nonelective contribution.)
Leveraging Safe Harbor to Increase Employer Contributions to Owners and HCEs
Many employers wish for the business owners (and perhaps other HCEs) to receive more than the maximum annual 401(k) contribution plus the safe harbor contribution. While doing so is possible with a discretionary profit sharing or matching provision, it is often determined to be cost-prohibitive because those contributions must be made uniformly to all eligible plan participants, including NHCEs.
There is a special type of employer contribution, however, that can enable the employer to make significant additional contributions to the accounts of owners/HCEs with only a nominal increase to the employer contributions made to NHCEs (or in some cases no increase at all). This is accomplished with an “age-based” (sometimes referred to as “cross-tested” or “new comparability”) employer profit sharing contribution provision.
Age-Based/ “Cross Tested” Profit-Sharing
Because an age-based profit sharing contribution is a type of nonelective contribution, it is included in the same set of nondiscrimination/actuarial testing as the safe harbor 3% nonelective contribution. This enables the employer to “layer” profit-sharing contributions on top of a safe harbor 3% nonelective contribution in a way that significantly – and legally – skews those additional profit-sharing contributions in favor of owners and HCEs.
Because the nondiscrimination/actuarial testing is age-based, this “layering” concept only works in situations where the owners/HCEs who are being targeted for additional profit-sharing contributions are – on average – older than the NHCEs.
It should be noted that – because a safe harbor 3% nonelective contribution creates a 3% contribution “base” in the testing of nonelective contributions – safe harbor 3% nonelective works better than the safe harbor 4% matching option with an age-based profit sharing contribution.
Many employers use this plan design (safe harbor 3% nonelective plus discretionary age-based profit sharing) as the lowest-cost method to maximize annual contributions to the 401(k) plan for owners at the IRS total annual contribution limit of $61,000 ($67,500 for those age 50+), and at a relatively low employer contribution expense for NHCEs.
Timing Requirements for Including a Safe Harbor Contribution Provision in a New or Existing 401(k) Plan
For a brand new 401(k) plan to include a safe harbor contribution provision in its initial year, employees must be able to make 401(k) salary deferral contributions for at least the final three months of the year (i.e., starting no later than the first payroll of October for a calendar year plan). Because it typically takes at least six weeks to get a new 401(k) plan set up to start receiving contributions, it is recommended that the setup of a new safe harbor 401(k) plan begin no later than mid-August.
Existing non-safe harbor 401(k) plans can wait and see whether the plan passes the ADP test, and – if the plan fails the ADP test – the plan sponsor can elect to amend the plan retroactively to make the plan safe harbor for the year of the ADP testing failure so that corrective refunds to HCEs are not required.
For a detailed description of the timing requirements for including a safe harbor contribution provision in a new or existing 401(k) plan, please see our article here.
In addition to demonstrating the employer’s commitment to helping employees save for a comfortable retirement, a safe harbor provision has several advantages. Most importantly, it exempts the plan from the ADP test and enables the employer’s owners and highly-compensated employees (HCEs) to maximize 401(k) contributions at the annual IRS limit without the possibility of corrective taxable refunds. For businesses for which the owners tend to be – on average – older than NHCEs, a safe harbor provision creates a contribution “base” on which additional profit sharing contributions can be layered to disproportionately favor the targeted owners and HCEs.
There are different considerations in determining whether a safe harbor contribution provision is a good fit for an employer and its 401(k) plan. TRPC works with hundreds of employers to implement and administer safe harbor 401(k) plans, and we welcome an opportunity to speak with you whether you are considering adding a safe harbor provision to an existing 401(k) plan or starting a brand new safe harbor 401(k) plan.
To learn more, please contact The Retirement Plan Company, LLC at 888-673-5440, option 4.