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.
Employers that are establishing a new 401(k) plan are often unaware of an IRS-required compliance test that can significantly limit the annual 401(k) contribution amounts of owners and other key personnel. The “actual deferral percentage” (ADP) test limits the group of owners and “highly compensated employees” (HCEs) to an average 401(k) contribution percentage that is only 2% greater than the average 401(k) contribution percentage of the “non-highly compensated employee” (NHCE) group. If the difference is greater than 2%, the HCE group must take “corrective taxable refunds” to bring the plan down to the 2% threshold.
Fortunately for employers, by making a “safe harbor” contribution the plan is given an exemption to the ADP test and the owners and HCEs are able to maximize their annual 401(k) contributions without any possibility of corrective taxable refunds.
Safe Harbor Contribution Options
The safe harbor contribution is typically written into the plan document as a “fixed” contribution (i.e., as a promise to employees). The employer has two different options for making a safe harbor contribution:
1) Safe Harbor 3% Nonelective – “nonelective” means not conditioned on the employee making 401(k) salary deferral contributions. This contribution is equal to 3% of gross compensation to all employees who are eligible for the plan whether or not they are contributing 401(k).
2) Safe Harbor 4% Matching – this contribution is made only to employees who make 401(k) salary deferral contributions. The minimum IRS-accepted matching contribution formula is equal to a 100% match on the first 3% of 401(k) contributions and 50% on the next 2% of 401(k) contributions (for a maximum matching contribution of 4%).
Another Option: Safe Harbor “Wait-and-See”
A third, lesser-known option is available to employers who require more flexibility with their employer contributions. Many employers cannot commit to making one of the two types of safe harbor contributions listed above. Some employers do not have it in the budget to be able to say with certainty that they’ll be in a position to fund the contribution each year. For other employers – particularly those establishing a brand new 401(k) plan – the employer feels that there’s a possibility that they’ll pass the ADP test described in the first paragraph above (in which case it isn’t necessary to make a safe harbor contribution). For these two types of employers in particular, the safe harbor “wait and see” option tends to be a good fit.
How Does Safe Harbor “Wait and See” Work?
First, it should be noted that the safe harbor “wait-and-see” approach can only be used with the 3% nonelective option; the IRS prohibits its use with the 4% matching option (presumably because employee 401(k) contribution patterns are so heavily influenced by the presence of an employer match). Here’s how the safe harbor “wait-and-see” approach works:
1) Instead of the plan document being drafted to include a “fixed” safe harbor nonelective or matching contribution, it is drafted to specify that the employer might make a safe harbor 3% nonelective contribution each year.
2) The employer is then given until December 1 of each year to decide whether or not the safe harbor 3% nonelective contribution will be made for the year, and the employer must distribute a notice to employees indicating whether or not the contribution will be made (the notice is prepared by the plan’s TPA).
3) If the employer chooses to make the safe harbor contribution for the year, the plan is exempt from the ADP test and the owner(s) and HCEs can maximize their 401(k) contributions for the year.
4) If the employer chooses not to make the safe harbor contribution for the year, the plan is subject to the ADP test, which will limit the owner/HCE group to an average 401(k) contribution percentage of no more than 2% greater than the average 401(k) contribution percentage of the NHCE group.
The safe harbor “wait and see” approach is a very good option for employers who would like for owners and HCEs to maximize their 401(k) contributions, but who can’t commit to making the safe harbor contribution every year. The “wait and see” option enables the employer to wait until November to decide whether it will make the safe harbor contribution for the year. For any year in which the safe harbor contribution is made, the plan is exempt from the ADP test and the owners and HCEs can maximize their 401(k) contributions. For any year in which the safe harbor contribution is not made, the plan is subject to the ADP test and the owners and HCEs are limited to an average 401(k) contribution percentage that is 2% greater than the average 401(k) contribution percentage of the NHCE group.