Most U.S. businesses rely on safe harbor 401(k) plans to stay compliant with the Internal Revenue Service and to ensure that each employee, regardless of salary and income, can maximize their company 401(k) plan experience.

According to Employee Fiduciary, a 401(k) plan provider for small companies, 68% of small businesses deploy safe harbor 401(k) plans in their employee benefits arsenal.

That figure shows, business owners believe in safe harbor 401(k) plans. For retirement savers, it's worth understanding why so many companies take the safe harbor route with their 401(k) plans.

What Is a Safe Harbor 401(k) Plan?

A safe harbor 401(k) plan is an employer-sponsored retirement plan that enables small business owners to avoid IRS annual compliance tests, and to ensure equal benefits and access to its 401(k) plan for all of its employees.

Safe harbor plans differ from traditional 401(k)s in one major regard - employers must make annual contributions to the plan on behalf of employees and those contributions must be immediately vested. 

Regular 401k plans don't have mandatory contributions and don't mandate immediate vesting. With a traditional 401k, the employee's contribution is immediate, but any employer contribution can be vested over time. That's the difference.

In going with a safe harbor, small businesses aren't subject to the paperwork-heavy annual non-discrimination tests that apply to regular 401(k) plans.

With safe harbor 401(k) plans, business owners must offer employees either an eligible matching or so-called non-elective contribution and each must be available to all employees. Employers have several contribution options under safe harbor 401(k) rules.

Here's a look:

A basic match

In this scenario, a company electing to use a safe harbor 401(k) plan provides 100% matching on the first 3% of a staffer's deferred compensation, plus an additional 50% match on any deferrals that range between 3% and 5%, but no more than 4% of a worker's total annual compensation.

Enhanced match

Here, a company deploying a safe harbor 401(k) plan can use a plan model that, at a minimum, must meet the basic match criteria at each worker's employee-deferred percentage compensation level. In most cases, that means a plan model using a 100% match on an employee's first 4% of deferred compensation.

Non-elective contribution

In this scenario, an employer contributes at least 3% of each employee's compensation, no matter if the employees request the contribution or not - it's done so automatically.

A Look at the IRS Non-Discrimination Tests

In offering safe harbor 401(k) plans to workers, companies are avoiding the onerous Internal Revenue Service non-discrimination plans.

According to IRS statutes, a safe harbor plan exempts companies from having to take the tests, which essentially compare how companies treat staffers with different compensation levels in deploying 401(k) plans.

The IRS offers four annual tests to clarify a company's 401(k) picture:

1. The Actual Deferral Percentage (ADP) Test

This test calculates how much money a highly compensated employee (i.e., an employee who earns at least $125,000 in 2019 or who has a 5% stake or higher in the company) contributes to a company 401(k) plan, relative to his or her less-compensated workplace peers, based on employer contributions.

2. The Actual Contribution Percentage (ACP) Test

This test is meant to check whether highly compensated employees are deferring significantly more financial assets to a company plan in terms of overall contributions.

3. The Top-Heavy Test

This test calculates whether the entire company's 401(k) plan assets account for more than 6% of all total company 401(k) plan assets.

4. The Coverage Test

This test aims to make sure that there is widespread access to and participation in a company's 401(k) plan - from all employees. It does so by measuring the ratio of lower-compensated staffers to higher-compensated ones, using a pre-set formula. If a company doesn't have a ratio of 70% of lower-compensated employees to higher-compensated employees, it fails the test.

If an employer fails any of the above tests, that company will be subject to 401(k) plan fees and penalties.

Instead of failing any of the above tests and having to deal with the IRS, the safe harbor 401(k) plan bypasses the exams altogether - that's why so many companies use them.

Why the Need for Safe Harbor 401(k) Plans?

For decades now, the traditional 401(k) plan has helped millions of Americans save for retirement in a tax-advantaged way. Companies have gone out of their way to aid employees in maximizing their 401(k) plan experience, using tools like matching contributions, automatic contributions, and access to financial advisors and other retirement planning specialists in order for staffers to get the most from their 401(k) plan.

The safe harbor 401(k) takes that employer support and raises it to another level, and Uncle Sam is behind the curtains pulling the operational levers. That oversight starts with the Internal Revenue Service, which has established the non-discrimination tests cited above to ensure a company 401(k) plan doesn't unduly favor more highly compensated employees.

Companies, especially smaller companies that can't afford the regulatory scrutiny and potential fines and paperwork, have taken due notice of the IRS tests. If one fails such a test, the fines can be heavy, the paperwork substantial, and above all else, the IRS now has that company on its radar - and no company executive wants that.

Enter the safe harbor 401(k).

The safe harbor 401(k) rescued company decision makers worried about failing IRS non-discrimination tests.

The safe harbor 401(k) is designed specifically to create an employer-sponsored retirement plan that aids every employee - not just the highly compensated ones - in benefiting from a 401(k) plan.

When companies sign on to this 401(k) plan model, they're essentially being granted a safe harbor from not only the non-discrimination testing mandate, but also the steep downside of getting on the wrong side of Uncle Sam by failing any of those tests.

The Takeaway on Safe Harbor 401(k) Plans

By and large, the biggest benefit to companies in opting for safe harbor 401(k) plans is to avoid the IRS non-discrimination rules testing mandates.

Uncle Sam gives great weight to the concept that highly compensated employees shouldn't be the major beneficiaries of a company's 401(k) plan largesse - thus the four tests companies must pass to avoid IRS oversight.

If an employer can meet the criteria for a safe harbor plan, including contribution, vesting and notice mandates, then they're likely in the clear and can establish a safe harbor 401(k) plan.

In the process, that company is ensuring a level playing field and equal benefits and access to its 401(k) plans - for all employees, and not just the highest paid ones.

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