Retirement Plan Services
PLAN DESIGN:
The Safe Harbor Solution for 401(k) Plans
Bob McKendry, CPC®,
QPA, QKA, CFP
Partner, Retirement Plan
Services
Direct: 904.224.9769
bmckendry@TheLBAGroup.com
01(k) retirement plans have been around for
some time and have grown in popularity over the
years. In many cases, small employers must offer
a 401(k) plan to attract and retain employees. The
401(k) plan offers employees a way to save for retirement on a tax-deferred basis with the added bonus of
employer contributions to supplement the employee’s
retirement savings.
4
Let’s look at a real world example of a safe harbor plan
in action.
Unfortunately, for many small employers, the 401(k) plan
design doesn’t offer much benefit to the owner of the
business. Federal regulations require annual nondiscrimination testing that often limits the amount the owners
and other highly compensated employees can contribute
to the plan. Low plan participation by rank-and-file employees results in nondiscrimination test failures which
require taxable refunds of 401(k) deferrals to the owners
and highly compensated employees.
Additionally, he complained, the plan is considered “topheavy” which required him to make an employer contribution to the plan for each rank-and-file employee equal to
three percent of their annual compensation.
Fortunately, employers can “buy” their way out of annual
nondiscrimination testing by adding a safe harbor contribution feature to their 401(k) plan.
Look at his current 401(k) plan (A):
There are two safe harbor contribution alternatives: (1) an
employer matching contribution of up to four percent of
compensation to those participants that make 401(k) deferral contributions to the plan or (2) a three percent of
compensation employer contribution to all eligible participants (regardless of whether they make 401(k) deferral
contributions). Both options must provide 100 percent
vesting of the safe harbor contribution.
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Background: A prospective client complained that his
401(k) plan was failing the annual nondiscrimination
testing on employee 401(k) deferrals. Consequently, he
was required to take large taxable refunds each year to
fix the test failure.
The prospective client was frustrated with his plan, felt
he was just not getting much benefit from the plan for
what it was costing him and thought it might be a good
idea to terminate his retirement plan and contribute to
an individual retirement account instead.
The owner has a 401(k) deferral rate of 8.5 percent
($17,000 in employee 401(k) deferrals divided by his
compensation of $200,000). The employees have an
average deferral rate of only 1.5 percent. This disparity
in deferral rates results in a nondiscrimination testing
failure that requires the owner to take a taxable refund
of $11,000 from the plan.
To make matters worse, the plan is top-heavy (more
than 60 percent of plan assets are held by the owner),
so that the employer is required to make a three percent of compensation top heavy minimum contribution for his employees.
Bottom-line, after the test failure refund, the employer must contribute $2,400 in employer contributions to end up with net 401(k)
contributions of $6,000 in his account. The result is an unhappy
business owner! We suggested he consider amending the plan to
add a safe harbor contribution feature.
Now look at a safe harbor 401(k) plan solution for this same
employer using a safe harbor matching contribution (B):
Using a safe harbor matching contribution, the plan is deemed to
pass the nondiscrimination test on 401(k) deferrals. Additionally,
under the safe harbor rules, the plan is deemed exempt from the topheavy minimum contribution requirements. Consequently, the owner
can defer $17,000 into the plan as employee deferrals without fear of
test failure refunds plus receive a safe harbor matching contribution
of $8,000 for a total of $25,000 contributed to his account.
The cost for employees in this case is actually less than the top-heavy
minimum contribution in the first example. Since the plan is considered
exempt from the top-heavy requirements, a top-heavy minimum contribution is not required. Employee 1 receives a 100 percent vested safe
harbor matching contribution on his 401(k) deferral equal to $1,500.
Employee 2 did not defer and receives no matching contribution.
The benefits of switching to this safe harbor matching approach are
significant. The cost for employees is decreased by $900 and the
contributions allocated to the owner are increased by $19,000.
Tax Note: Assuming the owner is in the 28 percent bracket for federal
income taxation, the owner’s tax savings from his personal plan contributions is $7,000. We assume the $25,000 the owner receives in
total contributions would be taken as additional taxable income if not
contributed to the plan. Instead of paying an additional $7,000 in federal income taxes, the owner contributes the $7,000 in tax savings to
A
Participant
Compensation
401 (k) Deferral
%
Owner
$200,000
$17,000
8.5%
Employee 1
$50,000
$1,500
3.0%
Employee 2
$30,000
$-0-
0.0%
the plan. The $1,500 contribution cost for his employees is more than
covered by his tax savings, so it is a “win/win” for the owner. He saves
$7,000 in taxes and the “IRS covers the cost” for his employees with
the surplus of $5,500 going to his own account.
Our prospective client was intrigued by the benefits of the safe harbor matching contribution, but wanted to know if we could do better.
We explained that using the three percent safe harbor contribution
approach would allow him to take advantage of a special nondiscrimination testing rule referred to as new comparability that could result
in an additional employer contribution to him.
Here’s a safe harbor 401(k) plan solution for this same employer using a three percent safe harbor contribution with a
new comparability profit sharing contribution to the owner (C):
Due to the three percent safe harbor contribution, once again the plan
is deemed to pass the nondiscrimination test on 401(k) deferrals and
the top-heavy minimum contribution requirement is satisfied. The
owner can defer $17,000 (or $22,500, if he is age 50 or older, under
the catch-up contribution rules) without fear of a test failure refund.
Additionally, employer contributions equal to nine percent of compensation, or $18,000, can be allocated to the owner under the new
comparability rules for total contributions of $35,000 to the owner.
The two employees each receive a safe harbor contribution equal to
three percent of compensation, regardless of whether they defer into
the plan, resulting in a total cost for employees of $2,400.
Note: It appears the employer contributions under this approach are
discriminatory with the owner receiving nine percent of compensation
and the employees only receiving three percent of compensation.
But, under the new comparability testing rules, the contribution
amounts are actuarially converted to benefit amounts at retirement
age and are shown to be nondiscriminatory in terms of the benefits
they will provide to the plan participants at retirement.
When we compare this safe harbor plan approach to the original
401(k) plan, the same
cost for employees of
Required Refund
Top Heavy
$2,400 allows the owner
Contribution
to increase his alloca$11,000.00
$ -0tions under the plan
from $6,000 to
$1,500
$35,000… a $29,000
increase!
$900
Total Employer Contribution ................................................................................................................$2,400
B
Participant
Compensation
401 (k) Deferral
%
Required Refund Safe Harbor
Matching Acct.
Owner
$200,000
$17,000
8.5%
$0.00
Employee 1
$50,000
$1,500
3.0%
$1,500
Employee 2
$30,000
$-0-
0.0%
$ -0-
$8,000
Total Employer Contribution ............................................................................................................$9,500
C
Participant
Compensation
401 (k) Deferral
%
Required Refund Employer
Contribution
Owner
$200,000
$17,000
8.5%
$0.00
Employee 1
$50,000
$1,500
3.0%
$1,500
Employee 2
$30,000
$-0-
0.0%
$900
$18,000
Total Employer Contribution ............................................................................................................$20,400
The bottom-line for frustrated 401(k) plan sponsors, there is hope for
your plan.
The regulations and
rules governing qualified
retirement plans offer a
lot of flexibility in designing a plan to meet the
employer’s needs. Often,
relatively simple plan
design changes, such
as adding a safe harbor
or new comparability
feature, can make a big
difference in the performance of the plan.
The moral of this story…
Talk to a retirement plan
professional before giving up on your 401(k)
plan. N
October 2012 : 904theMagazine.com : 55