At Gate City Advisors we work with several different retirement plans. We often discuss different plan design options with our clients. We teach them how to get the most out of their small business 401k/403b. One of the most common plan design features is the Safe Harbor feature. In order to understand the benefits of a Safe Harbor 401k it is important to first understand the testing that is required with a 401k plan.
The IRS classifies employees in a retirement plan into two different categories, highly compensated and non-highly compensated. A typical 401k plan is required to perform testing to ensure that the plan does not discriminate in favor of the highly compensated. Highly compensated is determined by an income amount ($120,000 or more in 2017), being 5% or more owner, and/or being a direct family member of someone who is 5% or more owner. All other employees are considered non-highly compensated employees.
The IRS wants to make sure that highly compensated employees do not receive more benefit than the non-highly compensated. They do this by requiring the plan to be tested. There are two primary tests in a 401k plan. There is ADP and ACP testing. ADP testing is Actual Deferral Percentage and is based on the amount an employee contributes of their own money to a plan. ACP testing is Actual Contribution Percentage testing and is based on the amount an employee receives from the company. There can usually be no more than a 2% difference between what a highly compensated employee defers into the plan or receives from the company than a non-highly compensated employee. If there is big difference between these the plan will fail testing and a refund will be due.
Safe Harbor Formulas
The IRS says that if you will adopt a level of contribution or match to all employees that they feel is fair, they will give a plan a Safe Harbor on testing and deem your plan to always pass the testing requirements.
The Basic Safe Harbor Formulas:
- A Match Formula
- Match each employee 100% of their first 3% of salary and then 50% of their next 2%.
- A Non-Elective Formula
- Give every employee 3% of their salary regardless if they contribute.
- An Automatic Enroll and Automatic Increase Formula
- 3 percent in the first year.
- 4 percent in the second year.
- 5 percent in the third year.
- 6 percent in all later years.
- But no more than 10 percent in any year.
- Matching 100% of the first 1% of salary and 50% of each additional 1% up to 6%.
In addition to these formulas, you must also vest each Safe Harbor company contribution immediately.
To see how a Safe Harbor 401k plan might benefit you and your employees, reach out to Gate City Advisors for a no obligation assessment of your retirement plan. To learn more about this and other retirement plan topics, you can sign up for our next Retirement Plan Workshop.
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