What You Need to Know About a Safe Harbor 401(k)

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For workers, a standard 401(k) plan offers a straightforward and tax-advantaged way to save for retirement, but for employers, setting up a 401(k) plan is anything but simple. Companies who want to offer 401(k) savings plans to their employees must ensure they don’t run afoul of complicated government rules.

A key regulation for most 401(k) plans is the requirement for annual nondiscrimination tests that are designed to prove a plan doesn’t unfairly favor certain employees. “The purpose of a safe harbor plan is to exempt the (business) from those tests,” says Allison Brecher, general counsel and chief compliance officer for Vestwell, a digital retirement platform. By setting up a safe harbor 401(k), a business can provide its employees with the same tax benefits as a regular 401(k) plan but skip the onerous annual testing requirements.

Read on to learn more about safe harbor 401(k)s, including how they’re set up, how they meet government requirements and ways to benefit from employer-matched contributions.

What Is a Safe Harbor 401(k)?

Before you learn the basics of safe harbor plans and how they’re structured, you must understand the government nondiscrimination testing for regular 401(k) accounts.

These tests analyze the savings rates of highly compensated employees compared to nonhighly compensated employees. For 2020, a highly compensated employee is categorized as a worker earning more than $130,000 annually or someone who owned more than a 5% interest in the business during the previous year.

Under these tests, there can’t be a large discrepancy between the groups in terms of what they are depositing into their 401(k) accounts. For instance, with the actual deferral percentage test, or ADP test, if nonhighly compensated employees are only putting an average of 4% of their income into their retirement plan, highly compensated employees will be limited to depositing 6% of their income.

The government-required tests also aim to assess whether the account contributions are top-heavy. To do that, the tests compare the fund assets of key employees to those of everyone else. A key employee is defined as an owner or officer of a business. If key employees own more than 60% of the assets in a plan, it is considered top-heavy and corrective action may be required.

“If you fail the testing, you end up having to give back (contributions) to the highly compensated employees,” says Eric Kristenson, retirement plan consultant with Canby Financial Advisors in Framingham, Massachusetts. Employers may also be required to make a 3% contribution for all its other employees.

“The purpose (of testing) is to ensure the plan is offered to a cross section of highly paid employees and nonhighly paid employees,” Brecher explains.

How a Safe Harbor 401(k) Sidesteps an IRS Nondiscrimination Test

With a regular 401(k), a company must pass the nondiscrimination testing every year, but plans that follow the safe harbor framework are assured of fulfilling government requirements. What’s more, highly compensated owners don’t have to worry about their contributions being capped by ADP testing.

“As an employer, you want to avoid the … limitations on contributions,” says Chris Keller, partner at Kingman Financial Group in San Antonio, Texas. With a safe harbor 401(k), everyone can contribute up to the $19,500 maximum in 2020, and those age 50 and older can make an additional $6,500 in catch-up contributions.

The trade-off is the company has to make mandatory contributions to employee 401(k) accounts, and that money becomes vested immediately. For a large company, that could be an expensive proposition, but a small business may find it is more cost-effective to make retirement contributions than deal with burdensome nondiscrimination testing. Safe harbor 401(k) plans are typically less expensive to set up than traditional plans.

Types of Safe Harbor 401(k) Plans

Safe harbor 401(k) plans can be set up with or without a match. Depending on which option an employer chooses, a plan is considered one of the following:

  • Nonelective safe harbor: With these plans, employers make a 3% retirement contribution for all workers, regardless of whether they choose to participate in the plan. “You could almost think of it as a profit-sharing plan,” Kristenson says.
  • Basic safe harbor: Also known as an elective safe harbor, this plan will match 100% of up to 3% of an employee’s contributions and then 50% of an employee’s additional contributions, up to 5%.
  • Enhanced safe harbor: As another type of elective plan, enhanced safe harbor 401(k) plans meet or exceed what is offered in a basic plan. Typically, they provide a 100% match of up to 4% of an employee’s contributions.

“We recommend the match (to clients) because it incentivizes employees to put into their own retirement,” Kristenson says. However, business owners should consult with a financial professional experienced in 401(k) accounts to determine which option is best for their needs.

Tax Benefits, Employee Advantages of a Safe Harbor 401(k)

A safe harbor 401(k) offers significant benefits to workers, including automatic employer contributions to their retirement fund, potential tax deductions and immediate vesting.

In 2020, employees can deduct from their taxable income up to $19,500 in contributions to a traditional 401(k) plan of any type. Workers age 50 and older are eligible for a total deduction of up to $26,000. Those who opt for a Roth 401(k) account don’t get an immediate tax deduction, but their retirement fund grows tax-free and money can be withdrawn tax-free after age 59 1/2.

Another advantage for workers is that employer contributions to safe harbor 401(k) plans are immediately vested. With a standard 401(k), an employee may have to work a certain number of years before they have full access to this money, but no such lengthy predetermined vesting schedule is in place with most safe harbor plans.

That means money deposited into a safe harbor 401(k) plan is an employee’s to keep, no matter what. “It’s free money, and it’s free now and forever,” Brecher says.

How to Start a Safe Harbor 401(k)

Employers who want to open a safe harbor 401(k) plan should seek out professional guidance. Some companies, such as Vestwell, offer free consultations to business owners, but others may charge for the service. Even if a business owner has to pay, it’s money well-spent, according to Brecher.

Accounting firms and payroll providers have traditionally served as plan administrators, but online solutions are gaining popularity. Another option is to get assistance from an advisory firm that can determine how a retirement plan fits into the big picture of company finances and goals.

Regardless of whether an accountant, financial advisor or another professional helps set up the plan, its official documentation must indicate it’s a safe harbor 401(k). Existing plans can only be converted to a safe harbor at the start of a new year, and notice of the decision to convert to a safe harbor plan must be made 30 days in advance.

The SECURE ACT, passed in 2019, makes now an ideal time to consider setting up a safe harbor 401(k), Brecher says. The law includes some significant tax credits that could cover the administration costs of a plan for three years.

A safe harbor 401(k) is a favorite retirement plan for many small businesses. Not only do these savings accounts make it easier for company executives to meet government rules, but they ensure workers receive minimum contributions toward their retirement, making it a win-win for employers and employees alike.



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