401k Plan Safe Harbor Provision

By Jason Watson, CPA
Posted Saturday, November 5, 2023

Solo 401k plans do not need a safe harbor provision- this is reserved for company-sponsored 401k plans. Regardless, we believe you should understand the rules.

Congress and the IRS want to ensure that self-employed 401k plans do not favor highly compensated employees (HCEs). To be a highly compensated employee you must

• either own more than 5% of the business or

• earn more than $150,000 in salary (for the 2023 tax year) and was in the company’s top 20% in terms of pay.

Therefore, nearly all small business owners are HCEs from an ownership perspective regardless of salary. There are three tests-

• You cannot defer more than 2% above the average deferral of non-HCEs. Take a standard deviation curve, go out 2%, and draw a line in the sand. This is the ADP test (Actual Deferral Percentage).

• Another test looks at matching contributions from the employer (your business). This is the ACP test (Actual Contribution Percentage).

• Lastly, the top-heavy test ensures that HCEs don’t have more than 60% of the entire plan’s value.

As a small business owner, it is easy to fail any of these tests and more likely all three. A common example is where you have several plan participants, but only your HCEs are deferring close to the maximum. This creates a top-heaviness to your small business 401k plan, and the tax code will fail your plan by suggesting it discriminates in favor of a few highly compensated employees. Not your fault of course since you cannot force your staff to make deferrals into the 401k plan, but if the cookie crumbles that way the plan fails.

If your 401k fails the ADP or ACP testing, there are two methods to bring the 401k plan back into compliance. One method is to make an employer contribution for all non-HCEs. The second method is more individualized where each HCE is refunded a portion of their contributions and those amounts are also contributed by the employer to all non-HCEs. Messy and complicated. Read IRS Revenue Procedure 2013-12 for more information.

But isn’t that the point? Isn’t the point of a self-employed retirement plan to give the people who are worth the most, the most of the business’s benefits and resources (i.e., the owners)? Of course, it is. At the same time, we must play by the rules. So, help is on the way through the Safe Harbor provision. You can defer the maximum, and also have the business match it, without the HCE testing. What’s the catch? There’s always a catch in the “harbor.”

A Safe Harbor plan must satisfy four requirements, with required contributions being the main one. This entails using one of the following formulas-

• Basic- Match 100% of the first 3% of compensation, plus 50% of the next 2% of compensation, or

• Enhanced- Match 100% on the first 4% of the compensation, or

• Non-Elective- Contribute 3% of compensation to all eligible employees

The first two options appear to be more in favor with small business owners than the third since you can take the chance that not all employees will contribute. In addition, the safe harbor 401k plan must have-

• 100% vesting for the required contributions,

• provide an annual notice to all participants, and

• contain withdrawal restrictions (no hardship withdrawals, for example).

However, if the business contributes more than the safe harbor amount, that portion may follow a vesting schedule.

Therefore, don’t run out and make your 401k a 401k plan with safe harbor provisioning just because you think you need it. If you do not see a problem passing the discrimination tests, then skip it. For example, you have a small business, the disparity of salaries is low, everyone is participating well and you as the owner are not overloading the plan. Your 401k plan might pass testing as is without having to add the safe harbor provision. Remember, under the safe harbor provision, the employer is required to make contributions according to one of the options above. So, there’s your catch.

One planning strategy is that if you require a 401k with safe harbor, you could use the required contribution to defer an annual raise. In other words, you could attempt to pass on an employee raise by contributing the obligatory 3% (for example) employer portion of a safe harbor 401k plan. Probably only one time though, unless you enjoy posting jobs and conducting interviews. Even the first attempt might be a bust.

As a side note, those employee groups that have a collective bargaining agreement can have a separate 401k plan. For example, airlines have pilots who are a large employee group and who have the most discretionary income among the other groups. Therefore, if the airline had one single 401k plan, it would probably fail ADP or ACP testing. Instead of electing safe harbor provisioning, the pilot group is allowed to have its own 401k plan under a collective bargaining agreement which isolates the plan from flight attendants, customer service, mechanics, etc. Who knew? I’ll take 401k plans for $600, Ken.