What Are Safe Harbor 401(k) Plans?

Making sure more people are saving for retirement is one of the goals of the IRS. One reason the IRS implements penalties for unqualified early retirement distributions is to prevent retirement accounts from being drained before the person retires. The IRS also conducts nondiscrimination tests to ensure 401(k)s aren’t weighing heavily towards employees who earn the most. However, without safe harbor 401(k) plans employers and employees can incur costly penalties.

Safe harbor 401(k) plans are a type of retirement plan that helps employers navigate the IRS’s nondiscrimination test. The structure of these unique 401(k) plans automatically passes the test or avoids it entirely. A safe harbor 401(k) plan allows high-earning employees to maximize their 401(k) contributions without the risk of penalty. Because two of the three safe harbor options involve employer matches, safe harbor match is sometimes used interchangeably with safe harbor 401(k) plans.

What is the IRS nondiscrimination test?

Ensuring the high-earning employees of a company aren’t disproportionately saving more for retirement through their employer-sponsored 401(k) is the main reason for the IRS’s nondiscrimination test.

Ideally, the IRS wants to see active 401(k) participation be equal across all employees.

The IRS tests each 401(k) plans to determine that the average contributions of the higher compensated employees don’t exceed the average contributions of everyone else by no more than 2%.

Highly compensated employees are those who make more than $130,000 in 2021—the same amount as in 2020—or own more than a 5% stake in the business.

What are the penalties for failing the nondiscrimination test?

Contributions deemed excessive can be rejected by the IRS. If the employer doesn't fix the plan by distributing or recharacterizing excess contributions, the plan’s tax-qualified status could be stripped. 

As a result, the business owner and their employees would owe federal and state income tax on the money. The employer would also owe Social Security, Medicare, and Federal Unemployment (FUTA) taxes. Additionally, employees would lose their ability to roll over their 401(k)s to another eligible retirement plan like an IRA. Excess contributions would also be assessed a 10% penalty tax.

How do safe harbor 401(k) plans work?

To avoid discrepancies in 401(k) plan participation by lower-earning employees, employers can automate its matching contributions to go to every employee, regardless of whether they participate themselves.

However, there is no long-term vesting schedule allowed with safe harbor 401(k) plans. Employer matching must be immediately vested, meaning employees keep the employer’s match if they leave the company, no matter how long they’ve been employed.

Employers can design a safe harbor plan to match contributions from employees who defer compensation or make contributions for every employee.

Employers can make contributions to its employees’ 401(k)s in one of three ways: 

• Non-elective: Eligible employees receive an employer contribution of 3% of their annual salary. This amount is fully vested immediately and whether or not the employee contributes to the plan. 
• Basic: The first 3% of the employee’s compensation is matched 100%, plus 50% of the next 2%. Employees must contribute to their 401(k) in order to get the match. 
• Enhanced: The employer’s match is at least equal to the amount that would have been provided under the basic allocation. Additionally, the ratio of elective contributions to non-elective contributions cannot increase as the employee's elective contributions increase.

How to set up a safe harbor 401(k) plan.

Consulting retirement plan providers is the best way to customize an existing 401(k) plan or set up a new plan with a safe harbor attached. Safe harbor provisions can be included with any retirement plan or 401(k) but require written notification and education for plan participants. Further, employees must receive a summary plan description within 90 days of becoming eligible for the plan.

Employers can add safe harbor amendments to their plans up to the 30th day before the end of the plan year ends to take advantage of its provisions.

However, because employer contributions must be continuously made, safe harbor 401(k) plans are better suited for businesses that receive steady revenue streams.