The IRS wants 401(k) plans to be used by all workers. It checks to make sure the highest-paid employees or business owners don’t max out their 401(k) plan contributions for the year while other employees contribute much less. The IRS wants to see that all take advantage of the plan, not just those with high-paying jobs. The IRS tests each retirement plan to make sure the average contributions of highly paid employees don’t exceed those of everyone else by more than 2%. Business owners can resort to safe harbor 401(k)s to avoid the compliance hassles and costs of meeting the test.
How Does a Safe Harbor 401(k) Work?
The IRS can reject a retirement plan contribution that it believes is excessive. If the employer doesn’t fix things, the plan could lose its tax-qualified status. One way to fix a plan is for the maximum-allowed contribution to be lower. That would put higher-paid workers in line with those who aren’t fully active. The other is to recast the excess contributions of highly paid workers as taxable income. If a plan loses its tax-qualified status, it costs you or the employee. You would owe federal and state income tax as well as Social Security, Medicare, and Federal Unemployment (FUTA) taxes. Workers could not roll over plan assets to other eligible retirement plans. There also would be a 10% excise tax on the excess contribution. A long vesting schedule isn’t allowed with safe harbor plans. Contributions are fully vested when they’re made. The company must give all workers instant ownership. That includes those who leave or are fired during the year. You have more options with a safe harbor plan. You can design your safe harbor plan to limit any matching contributions to those employees who defer compensation. You can also contribute for all workers, including those who don’t pay into their own plans. Plans can contribute in one of three ways: A safe harbor provision can be attached to any type of retirement plan or 401(k). Plan participants must get a lot of written notice and education. They must receive a plan description within 90 days of being covered by the plan. That is extra work, but it should be easy enough to execute after a plan is set up.
How to Set up a Safe Harbor 401(k)
Search online, or ask fellow business owners or financial professionals in your area to suggest retirement plan providers who can help you set up a 401(k) or custom retirement plan for your small business. Safe harbor 401(k) plans tend to be better for companies with steady revenue streams. Other 401(k) plans might be better choices if you think your business could have trouble consistently matching funds. You can structure a plan to be age-based. In that case, those closest to retirement age can receive more in employer contributions. Some plans break the employees into classes or tiers, with older or key employees given a larger profit share.
SECURE Act Provisions
The Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed into law in December 2019. It increased the limit for automatic increases in an employee’s deferrals from 10% to 15%. The SECURE Act also provides that companies can amend their plans to safe-harbor plans up until the 30th day before the plan year ends. Amendments after that time can still be allowed if they increase non-elective contributions by at least 4% for all eligible workers. The plan must be amended by the last day for paying out excess distributions for the plan year. That is typically the end of the following year. Correction - Dec. 9, 2022: This article has been updated to correct the rules for highly paid employees.
