What is the Most Popular Type of 401(k) Plan?
Safe Harbor 401(k) Plans are very popular with business owners and plan participants alike. The Safe Harbor 401(k) provisions have some very big benefits and a few drawbacks.
Beginning in 1999, the Safe Harbor rules were designed for 401(k) plans. These rules call for a company to make a specific contribution to each participant in the plan. If the rules are followed, a Safe Harbor 401(k) Plan is allowed a free pass on the Actual Deferral Percentage (ADP) test, the Actual Contribution Percentage (ACP) test and the Top Heavy minimum contributions.
A Safe Harbor 401(k) is a way to structure a plan that automatically passes the non-discrimination test or avoids it altogether, which could limit the amount the owners or highly compensated employees can contribute to the plan. A safe harbor plan essentially requires the employer must make contributions to each employee’s plan — the same percentage of salary for everyone.
How the Safe Harbor Plan Works
Under a Safe Harbor plan, the employer can match each eligible employee’s contribution, dollar-for-dollar, up to three percent of the employee’s compensation. Plus fifty cents on the dollar for the employees’ contribution between three and five percent. Alternatively, the employer can make a nonelective contribution equal to three percent of compensation to each eligible employee’s account, which is required even if the employee elects to not make a contribution to the plan. Each year, the company must make either the matching contributions or the nonelective contributions.
For example, for every contribution made by an employee, the company adds another 3% of their salary. The contribution is deductible to the employer but could have a direct impact on the employer’s cash flow. An employer is not required to elect a safe harbor option and can rely on passing the annual plan nondiscrimination tests involving deferral and contribution percentages.
Why is it so Popular?
The reason the Safe Harbor 401(k) plan is so popular is because it allows a small business owner and all its highly compensated employees to maximize their annual contributions, while also offering 401(k) plan benefits to all employees without having to satisfy various complex ERISA testing rules.
The main advantage of an employer using a Safe Harbor 401(k) plan is that the business owner can gain the right to make maximum employee deferrals without having to satisfy the complex ADP & ACP ERISA plan tests. The downside is that the employer will likely be required to have at least a minimum of a 3% tax deductible contribution to all eligible of employees based on their compensation.