From our partners at Vestwell, originally published 07.31.2023
In today’s competitive business landscape, offering the right benefits can set your business apart, helping you attract and retain top talent. One of the most valuable benefits you can provide is a robust retirement savings plan. Among the options available, safe harbor 401(k) plans have emerged as a favorite for many businesses.
The popularity of safe harbor 401(k) plans stems from their ability to bypass certain annual testing requirements, optimize tax benefits, and maximize savings for business owners and highly-compensated employees. In this article, we will outline the different types of safe harbor 401(k)s available and discuss the pros and cons of each.
Timing is essential when setting up a safe harbor 401(k) plan. For it to be effective for a given year, it must be in effect three months prior to the year-end date, typically by October 1st. Business owners need to sign up for a plan by August 24, 2023, in order to set up a safe harbor plan this year.
What is a Safe Harbor 401(k) Plan?
A safe harbor 401(k) plan is a type of retirement plan that automatically satisfies many of the annual compliance tests required for traditional 401(k) plans. These plans were designed with the convenience of the employer in mind, as they simplify administration and allow business owners to maximize their contributions.
There are several types of safe harbor plans, each with unique contribution structures and features. There are pros and cons to each type, so it’s essential to grasp the distinct features of these plans when determining the best fit for your business.
Need help designing a plan for your business?
Benefits of Safe Harbor
Administrative Benefits: One of the key benefits of safe harbor 401(k) plans lies in their exemption from certain compliance testing requirements. Safe harbor 401(k) plans bypass tests such as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP), which are standard for traditional 401(k) plans. This simplifies the administrative process and helps you avoid penalties and other potential costs.
Tax Benefits: Safe harbor plans allow businesses to deduct employer-matching contributions (up to the IRS limit) from their taxes, offering another pathway to savings.
Savings Benefits: In a safe harbor plan, the business owner (assuming they are also an employee of the business) can maximize their contributions to their own 401(k) account and receive matching contributions from the company.
Without a safe harbor plan, owners and high-earning employees may face limitations on their contributions based on the contributions of non-high-earning employees. Annual compliance tests (such as the ADP/ACP tests) are designed to prevent 401(k) plans from unfairly benefitting some employees more than others. If a traditional 401(k) plan doesn’t pass these tests, the employer must take corrective action, which can be time-consuming and costly. This can lead to “excess contributions” being returned or additional employer contributions being required.
Of course, the benefits of safe harbor plans come with some conditions. Employers must commit to contributing a certain amount to the plan every year. In most cases, these contributions become fully vested when made. This means that the money contributed by the employer to an employee’s retirement account immediately belongs to the employee and cannot be forfeited or taken away. However, it’s important to note that there is an exception for Qualified Automatic Contribution Arrangement (QACA) plans, which we explore in more detail below.
Safe Harbor Contribution Types
To help you understand your options, we will discuss the advantages and drawbacks of each type of safe harbor contribution.
Basic Safe Harbor 401(k) Match
For the basic safe harbor match, employers must match 100% of the first 3% deferred by each participating employee, plus 50% of the next 2% deferred. This effectively means that if an employee contributes at least 5% of their salary to the plan, they will receive a company match equivalent to 4% of their pay up to the deduction limit for that employee.
For example, suppose Employee A decides to defer 5% of their salary into their 401(k) account. Employee A’s annual salary is $50,000. Here is how to calculate the employer contribution:
Step 1: Calculate 3% of Employee A’s salary: 3% of $50,000 = $1,500
The employer must match 100% of Employee A’s contribution for the first 3% of their salary deferral ($1,500).
Step 2: Calculate 2% of Employee A’s salary: 2% of $50,000 = $1,000
The employer must also match 50% of Employee A’s contribution for the next 2% of their salary deferral. Employee A has deferred an additional $1,000 (2% of their salary). The employer will match 50% of this amount.
Step 3: Calculate the total employer match: Employer match for the first 3% deferred ($1,500) + Employer match for the next 2% deferred ($500) = $2,000
Pros of the basic safe harbor match: This contribution structure encourages employees to save more for retirement since their savings are matched to a relatively high percentage by the employer.
Cons of the basic safe harbor match: From an employer’s perspective, this can lead to increased costs if a large number of employees participate and contribute 5%.
Non-Elective Safe Harbor 401(k) Contribution
In a non-elective safe harbor 401(k) plan, the employer must contribute a minimum of 3% of pay for every employee who is eligible to participate in the plan, regardless of whether the employee chooses to defer contributions.
For example, suppose Employee B decides not to contribute to their 401(k) plan this year. Their annual salary is $50,000. Here is how to calculate the employer contribution:
Calculate 3% of Employee B’s salary: 3% of $50,000 = $1,500
The employer must contribute 3% of Employee B’s salary, even though the employee chose not to contribute to the plan.
Pros of the non-elective safe harbor contribution: The chief advantage of this approach is its simplicity. Since contributions are not dependent on employee contributions, the calculation and implementation are straightforward. This formula is great for smaller companies.
Cons of the non-elective safe harbor contribution: Since employers are required to contribute for all eligible employees, the overall cost can be higher than other safe harbor 401(k) plans, particularly for companies with a large number of employees.
Enhanced Safe Harbor 401(k) Match
If you’re looking to provide even more value to your employees, the enhanced safe harbor match could be a good fit. Rather than the standard safe harbor employer contributions, you can choose to increase the match to further boost your employees’ retirement savings. For example, eligible employees may receive a 100% match on deferrals up to 4% of their annual compensation. With this formula, employees would only need to defer 4% of their salary to get the full match, compared to 5% with the basic safe harbor match.
Suppose Employee C decides to defer 4% of their salary into their 401(k) account. Employee C’s annual salary is $50,000, and their employer offers a 100% match on deferrals up to 4% of compensation. Here is how to calculate the employer contribution:
Calculate 4% of Employee C’s salary: 4% of $50,000 = $2,000
The employer will match 100% of Employee C’s contribution for the first 4% of their salary deferral, so the employer will contribute $2,000 to Employee C’s account.
Pros of the enhanced safe harbor match: This added benefit can serve as a strong employee retention tool, as the additional contributions can be subject to a vesting schedule. Plus, employers can offer a formula that is easy for employees to understand and appreciate.
Cons of the enhanced safe harbor match: These extra contributions may be subject to additional compliance tests, depending on the contribution amount.
Qualified Automatic Contribution Arrangements (QACAs)
Qualified Automatic Contribution Arrangements (QACAs) are another type of safe harbor 401(k) plan in which the employer automatically enrolls any eligible employee who does not actively choose to opt-out or adjust their deferral rate.
In a QACA, the employer matches 100% of the first 1% of compensation that an employee defers and a 50% match on any additional deferrals above 1% and up to 6% of the employee’s compensation. QACAs allow employer contributions to be subject to up to a two-year cliff vesting schedule.
The automatic deferral rate for a QACA must start at no less than 3% of an employee’s salary. Each year, this rate must increase by at least 1% until it reaches a minimum of 6%. However, the deferral rate can continue to rise until it hits a maximum of 10%.
For example, suppose Employee D is automatically enrolled in the plan at a default deferral rate of 3%. Employee D’s annual salary is $50,000. Here is how to calculate the employer contribution:
Step 1: Calculate 1% of Employee D’s salary: 1% of $50,000 = $500
The employer must match 100% of Employee D’s contribution for the first 1% of their salary deferral.
Step 2: Calculate 2% of Employee D’s salary: 2% of $50,000 = $1,000
The employer must also match 50% of Employee D’s additional deferral between 1% and 6% of their compensation. Employee D has deferred an additional $1,000 (2% of their salary). The employer will match 50% of this amount ($500).
Step 3: Calculate the total employer match: Employer match for the first 1% deferred ($500) + Employer match for the next 2% deferred ($500) = $1,000
Pros of QACAs: These plans encourage participation and allow employer contributions to be subject to up to a two-year vesting schedule. This can act as a powerful retention tool, incentivizing employees to stay with the company longer.
Cons of QACAs: With increased employee participation in a plan, the matching contribution costs also rise. Plus, although auto-enrollment may streamline processes over time, introducing it requires developing new communication materials and could mean additional work for the payroll team up front.
Setting Up a Safe Harbor 401(k) Plan
No matter which contribution formula you choose, a safe harbor 401(k) plan can be a boon for your business. Safe harbor plans can help you simplify retirement plan administration, optimize tax benefits, and maximize savings.
The ideal plan for your company depends on your specific goals. Are you looking to maximize your personal contributions as an owner, or is ease of administration your main focus? No matter your objective, CPSGo Retirement Services and Vestwell are here to help you design a plan that fits with your goals. While we handle the heavy lifting, you can focus on what matters most—your business.
Don’t miss out on the benefits of starting a safe harbor 401(k) plan. Remember, business owners need to sign up for a plan by August 24, 2023, in order to set up a safe harbor plan this year. Take the first step towards a brighter financial future for your business and book a demo with us today.