Simplifying 401(k) plan administration: the Safe Harbor design
Get all the benefits of a 401(k) retirement plan for your business without all the complexities.
Over the past few decades, 401(k) plans have become the most popular retirement plans offered to American workers — and for good reason. Along with allowing you and your employees to save for retirement, 401(k) plans can help you attract and retain talent.
As an added incentive for businesses with 100 or fewer employees, the government offers up to $5,000 per year in tax credits for the first three years after starting a 401(k), plus an additional $500 for choosing a feature called automatic enrollment.
What’s automatic enrollment?
Automatic enrollment is when employers automatically enroll new employees in their 401(k) plan instead of requiring them to do so themselves. This approach lets employees start saving right away. Employees can always opt out or change the way their money is invested. In a recent survey, 79% of participants were in favor of or neutral toward automatic enrollment, and 100% of participants who were automatically enrolled in their employer’s plans were satisfied.
Despite all the benefits of standard 401(k) plans, business owners must perform a number of complex compliance tests each year. These tests are designed to prevent discrimination in favor of business owners and other employees who meet the ownership or compensation requirements of highly compensated employees (HCEs).
Three types of compliance tests for a standard 401(k)
Actual deferral percentage (ADP) test — compares the average percentage of salary contributed to the plan by HCEs with the average percentage contributed by employees who are non-HCEs
Actual contribution percentage (ACP) test — compares employer matching contributions made for HCEs with those made for non-HCEs
Top-heavy test — measures whether more than 60% of the plan’s assets are in the accounts of the business owners and other key employees
The consequences of failing any of these tests can be burdensome and expensive for employers, possibly requiring them to issue refunds to HCEs and, in some cases, to fund additional employee contributions.
The ADP test in action
If non-HCEs contributed, for example, an average of 2% of pay to the plan, the average of contributions made by HCEs would be limited to 4% for that year. If HCEs’ contributions average more than 4%, a portion of their contributions must be returned to them.
Introducing Safe Harbor
There is a way to establish a 401(k) plan and avoid many of the annual compliance tests. It’s called a Safe Harbor plan. This type of plan automatically satisfies the nondiscrimination rules previously described. Therefore, the ADP and ACP tests don’t apply, and the amounts HCEs can contribute to the plan are not limited by what the rest of the workforce contributes.
A Safe Harbor plan is also exempt from the top-heavy test, except when an employer makes contributions other than the required Safe Harbor match or nonelective contribution described in the next section. For example, in the case of a profit-sharing contribution, the top-heavy test may need to be performed. If the test indicates that the plan is top-heavy, the employer may be required to make additional contributions to the plan.
In exchange for the relief from much of the testing and other administrative burdens, employers that opt for a Safe Harbor 401(k) must make annual contributions on behalf of their employees and follow other requirements depending on their 401(k) design choice.
Safe Harbor 401(k) design choices
A Safe Harbor 401(k) can be designed two ways — a traditional Safe Harbor 401(k) and a qualified automatic contribution arrangement (QACA). Both avoid the need for testing and require the employer to make contributions for participants. However, some important differences are outlined in the table.
Traditional Safe Harbor 401(k) versus qualified automatic contribution arrangement (QACA)
| Traditional Safe Harbor 401(k) | Qualified automatic contribution arrangement (ACA) | |
|---|---|---|
| Enrollment | Employees may enroll in the plan themselves, or you can enroll for them. Either way, you must contribute to the plan according to one of the following formulas. | Unless an employee chooses not to participate, you must automatically enroll eligible employees in the plan and deduct at least 3% of their pay to be contributed to the plan. Each year thereafter, the employee’s contribution is automatically increased by at least 1% until at least 6% is reached, but the plan can stipulate that these automatic increases cap out as high as 15%. Additionally, you must contribute to the plan according to one of the following formulas. |
| Contributions | Matching contribution The employer matches 100% of the first 3% of pay that employees contribute to the plan plus 50% on the next 2% they contribute. Example If an employee contributes 5% or more of their pay, you will be required to make a 4% matching contribution. Nonelective contribution You contribute 3% of pay for all eligible employees — even those who don’t contribute to the plan. |
Matching contribution The employer matches 100% of the first 1% of pay that employees contribute to the plan and an additional 50% on the next 5% they contribute. Example If an employee contributes 6% or more of their pay, you will be required to make a 3.5% matching contribution. Nonelective contribution You contribute 3% of pay for all eligible employees — even those who don’t contribute to the plan. |
| Vesting | The Safe Harbor contributions — whether matching or nonelective — are always fully vested. | The Safe Harbor contributions — whether matching or nonelective – must be fully vested once the employee completes two years of service. |
Which Safe Harbor design is right for your company?
When choosing between a traditional Safe Harbor 401(k) and a QACA, consider these important questions:
- Immediate or delayed vesting?
With the traditional Safe Harbor 401(k), employer contributions are fully vested when made. However, with the QACA, those contributions can be subject to a two-year vesting schedule. Employees who leave before their two-year work anniversary forfeit the amount in their employer contribution account. The forfeited funds can be used to offset the required employer contribution in future years.
- Automatic enrollment or opt in?
Automatically enrolling employees in a 401(k) has been shown to be an effective way of helping employees build retirement savings. Automatic enrollment is optional in the traditional Safe Harbor design but required for QACAs.
- Matching or nonelective contribution?
With the nonelective contribution option, a 3% contribution is made for all eligible employees, including those who do not contribute their own money to the plan. With the matching contribution option, contributions are made only for employees who contribute themselves. Because the basic matching formulas for the traditional Safe Harbor 401(k) and the QACA differ, the potential cost to you will vary depending on the number of contributing employees and the rates at which they contribute.
For example, if you opt for a traditional Safe Harbor design and all eligible employees contribute 5% or more of their pay, your matching cost will be 4% of payroll. However, in a typical plan, some employees opt out or choose to contribute less than 5%, so your cost will usually be less than 4%.
On the other hand, if you choose the QACA design and all eligible employees contribute 6% or more of their pay, your matching costs will be 3.5% of payroll.
Safe Harbor 401(k) deadlines
If you’re considering establishing a Safe Harbor 401(k), you need to know some important deadlines:
- New plans — For the plan’s first year, employees must have the opportunity to contribute for at least three months. Therefore, for a 401(k) plan that operates on a calendar year (as is the case with most plans) the plan must be effective no later than October 1.
If you choose the QACA design or will be making matching contributions, employees must be given a notice at least 30 but no more than 90 days prior to the effective date of the plan. Each year thereafter, the notice must be furnished between October 1 and December 1.
- Existing plans — You can amend an existing standard 401(k) to add a Safe Harbor feature. The plan can be amended for the calendar year to add this feature as late as November 30 of that calendar year if you will be making a 3% nonelective contribution.
A recent change in the law allows you to wait as late as the end of the following year if you’ll make a 4% instead of a 3% nonelective contribution. A plan can be amended to add a Safe Harbor match only as of the beginning of the calendar year. In that case, employees must be notified at least 30 days before the start of the year.
Take the next step
Everyday 401(k) by J.P. Morgan was built with you and your employees in mind. If you’re interested in establishing a retirement plan for your business and want to speak with a Retirement Plan Specialist, stop by a local Chase branch, complete this intake form or call 833-JPM-401K.
