A good retirement plan is one of the most compelling perks prospective employees look for when applying for work. Therefore, many business owners have sought ways to provide excellent retirement benefits as incentives to workers.
However, when it comes to the 401k, one of the most common types of retirement plan, employers need to be aware of the IRS compliance tests that ensure fairness for all employees. If retirement plans unfairly prioritize higher earning employees, they will fail the IRS’s testing requirements and the business owner will be subject to hefty fines and tons of administrative paperwork.
Luckily, there is a solution that allows businesses to pass these tests without a second thought: The Safe Harbor 401k.
In this guide, we will give an overview of a Safe Harbor 401k so that you can determine if it is the right option for your business.
Safe Harbor 401k: Why Is It Necessary?
A Safe Harbor 401k provision ensures that the three annual IRS tests of fairness are met by all businesses who offer 401k plans. The three IRS tests are:
- The Actual Deferral Percentage Test. The ADP test is administered to ensure that the percentage of 401k contribution from “highly compensated earners” (HCEs) within the company is not significantly higher than that of the average contribution rates made by lower-wage employees.
- The Actual Contribution Percentage Test. The ACP test is in place to make sure that employer matching contributions for HCEs are fair when compared to lower-earning workers.
- The Top-Heavy Test. A plan is considered to be “top-heavy” if the business owner and other higher-earning employees hold more than 59% of the plan balance.
As was mentioned in the introduction, failing one or more of these tests creates an unfavorable scenario for the business owner. Massive amounts of paperwork and fines await the individual who fails any of the IRS compliance tests.
But how does the Safe Harbor 401k provision help businesses to pass these IRS tests?
The Safe Harbor 401k ensures fairness by requiring businesses to match employee contributions in one of three ways:
- Basic Matching. Basic matching requires the company to match 100% of all 401k contributions made by employees, up to a maximum of 3% of their yearly salary, plus a 50% match of the next 2% of employee contributions.
- Enhanced Matching. Enhanced matching implies that the company matches at least 100% of employee contributions, up to as much as 4% of their compensation.
- Non-elective Contributions. With non-elective contributions, the business must contribute 3% or more of each worker’s compensation, no matter how much or how little these employees have contributed to their 401k plans themselves.
How Do I Set Up a Safe Harbor 401k Plan for My Business?
There are a few important deadlines to keep in mind if you wish to set up a Safe Harbor 401k plan for 2021:
- To start a new Safe Harbor Plan, the deadline is October 1st
- To add a Safe Harbor Provision to an existing Plan, the deadline is November 30th