Our company is in business to help design and administer small business 401k plans, so of course we think that every company should sponsor a plan.  It’s OK if the small business owner designs their 401k plan to benefit himself or herself and the key employees because there is generally an opportunity for all employees to participate and save for their future.

Now that we’re approaching year end we are doing a lot of planning, and getting a lot of inquiries about 401k plans from small business owners.  We have a white paper here on our website about plan design options available (CLICK HERE Or View our related article Small Business 401k Plans - What are your options?), but today I want to focus on some of the risks that small business owners are taking with their 401k plans.  Poor plan design, failure to understand the complexity of some of the rules, and delegating responsibility for the plan without proper policies and procedures in place all pose risks for the small business 401k plan.

 

THE RISK TO ELIMINATING SAFE HARBOR PROVISIONS

The Safe Harbor rules were put in place to help small businesses pass two critical 401k compliance tests:

         1. ADP test.  The Actual Deferral Percentage (ADP) test compares the average rate of 401k contributions for the Highly Compensated Employees (owners and their immediate family, and those making more than $115,000 per year), to the average rate of 401k contributions for the Non-Highly Compensated Employees.  If the HCE group defers an average of more than about 2% over the average of the NHCE group, then the ADP test fails.  To correct a failed test the HCE group must take back some of their contributions to reduce their average, or the company must make a contribution to the NHCE group to bring their average up.

There is a similar test called the Actual Contribution Percentage (ACP) test that compares the matching contribution rates for the HCE and NHCE groups.

         2. Top Heavy.  When 60% of the value of the plan is held in the accounts of Key Employees (Owners and immediate family, or corporate officers earning more than $165,000), then the plan is considered Top Heavy.  When a plan is Top Heavy, then the company is obligated to make a contribution to the non-Key Employees – usually 3% of pay. 

 

If a small business 401k plan adopts Safe Harbor provisions, then they automatically pass the ADP/ACP, tests, and the Safe Harbor contribution meets the Top Heavy minimum too.  Safe Harbor provisions require a modest company contribution or company match, contributions must be 100% vested immediately, and the employees must receive notice 30-days before the beginning of the year about the plan’s Safe Harbor status for the upcoming year.

One of the risks to small business 401k plans is that the Safe Harbor provisions are eliminated without understanding the consequences of the testing requirements outlined above.  Upon elimination of the Safe Harbor provisions, the Highly Compensated Employees may have to significantly curtail their contributions to the plan, and if any Key Employee makes a contribution to the plan, then Top Heavy minimum contributions may be required anyway. 

Some small business 401k plans do not need to adopt Safe Harbor provisions because they have good participation among the Non-Highly Compensated Employees so that the Highly Compensated Employees can save what they want.  The small business owner should make sure that he or she understands the risk to eliminating a Safe Harbor provision before moving forward with that decision.

 

SUMMARY

Small business owners take a risk just by opening their doors, and add to that risk when they take on employees.  To reduce risk in a small business 401k plan the business owner needs to take some steps to insure that his or her internal procedures are in good shape.  They can reduce their risk further by studying 401k rules extensively, or by hiring a local TPA like Benefit Resources to help them oversee their plan.  Think of it as an inexpensive insurance policy.  If you have any concerns about your plan, CLICK HERE to find out how you can have a free initial review of your plan.