You may not be surprised to learn how common it is for business owners to finally put pencil to paper in an effort to get their new 401(k) plan in place only after they’ve wrapped up their tax return that’s been extended until September. Unfortunately, a significant number of these business owners come to find that the difference between a 401(k) plan with a safe harbor provision versus one without may be the difference between a retirement plan that’s worth sponsoring or electing to continue to postpone and the deadline for starting a new plan with this provision is October 1st for plans using a calendar year. If on a fiscal year, the rule is that the plan must be in effect for at least three months for the safe harbor provision to be valid. What is a safe harbor 401(k) plan? You may find the answer in another of our blogs, Safe Harbor Plans – 10 Questions Answered!
So, you like a safe harbor provision but here it is too late this year to include it with your new 401(k) plan? There are still options for you and this article may help you decide how you’d like to proceed. To streamline the conversation, here are some helpful definitions:
- HCE: Stands for “highly compensated employee” who is typically either an owner of more than 5% of the company sponsoring the plan, a relative of someone who meets this criterion, or a non-owner who earned sufficient income in the prior year ($150,000 indexed for 2023)
- NHCE: Stands for “non-highly compensated employee” and is basically the classification for everyone who is not an HCE
- Key employee: An owner of more than 5% of the company sponsoring the plan, a relative of someone who meets this criterion, an owner of more than 1% of the company who earned sufficient income in the prior year ($150,000 indexed for 2023), or an officer of the company who earned sufficient income in the prior year ($215,000 indexed for 2023)
- Former Key employee: A person who once was classified as Key but no longer does
- Non-Key employee: The classification for everyone who is not classified as Key or Former Key
- QNEC/QMAC: Stands for “qualified non-elective contribution” or “qualified match contribution” and is a 100% vested company benefit to certain employees to correct failed testing
- Top-heavy: A status for plans where 60% or more of collective trust assets belong to Key employees (plus or minus some types of assets or recent transactions)
Option 1: Potentially (likely) fail the Average Deferral Percentage (ADP) test
Safe harbor provisions were invented in 1999…turns out we have practice at this! Safe harbor provisions protect deferral contributions from HCEs and as long as safe harbor contributions are the only ones the company makes, it also offers protections from “top-heavy” 3% minimum contributions. If there is no safe harbor provision NHCEs won’t know the difference, but HCE deferrals may be adversely affected if, on average, they defer at a rate greater than 2% or more than the average NHCE (this is often the case, but exceptions exist). This is called the Average Deferral Percentage (ADP) test. In order to correct a failed ADP test, it’s essentially a balancing act: The choice is to either refund some deferrals to HCEs (corrective distribution, must be done before 2 ½ months from the close of the plan year) or provide additional QNEC/QMAC contributions to NHCEs in order to balance out the benefit for the year per ERISA regulations. If the numbers are close (but not close enough), the corrective distribution or QNEC/QMAC may not have much of an overall impact.
Option 2: Use Prior Year Testing (Deemed 3% NHCE deferral rate that first year)
If you were planning on making a profit sharing contribution, anyway, there’s another little-known option for first year plans this includes leveraging a ADP test option which deems an NHCE deferral rate of 3% regardless of how much they actually use the plan. This requires making a document election for ADP testing called “prior year testing” where instead of considering current year NHCE deferral rates, the administration of the plan would instead consider NHCE deferral rates from the prior year. This option is beneficial for plans that don’t intend to include a safe harbor provision since it provides the average deferral limit for HCEs ahead of time so they can intentionally restrict their use of deferrals in order to be sure to pass ADP testing. For first year plans, though, where there is no prior year, regulations allow the plan to use a “deemed 3%” NHCE deferral rate for testing purposes. This means, using the math I mentioned earlier, that HCE deferrals will pass ADP testing if the average rate does not exceed 5%- not bad! For example, if an owner makes $200,000 and his wife also works for the company but chooses not to defer at all, the owner could defer up to $20,000 and still meet testing requirements! Here’s the rub: Since the plan was not in place very long and NHCEs probably didn’t make much of it that first year, it is very easy for the plan to top heavy and therefore become subject to a mandatory (subject to vesting, though) company contribution equal to at least 3% of full-year compensation for qualifying (likely most) non-Key employees. Fortunately, this means a zero-dollar increase in plan funding if you were already planning on making a 3+% profit sharing contribution for the year! Then, before the next plan year begins, you would amend that safe harbor provision you couldn’t include year one into your plan and change the ADP testing year back to “current” and you’re good to go!
Option 3: Start the plan for your employees, just don’t use it yourself until next year
If the HCE deferral rate is 0%, guess what? You passed the ADP test. Guess what else? The plan is not top-heavy. Sure, you paid a lot of up-front expenses to put a plan in place you couldn’t use, but you did get a pretty nice new plan tax credit (thanks, SECURE Act 2.0!) and your employees have the proven best way to begin their path toward saving for retirement in a payroll-deduction 401(k). You are able to prospectively include a safe harbor provision into your plan which doesn’t go into effect until the upcoming year, so once that day comes, you’re finally able to use it!
Option 4: Start the plan, but expect your only benefit to be from the company
This can be the same as Option 3, but don’t forget that you can still benefit from a profit sharing contribution! Heck, you don’t even have to put the plan in place until the due date of the company tax return in order to use it this way…
At Benefit Resources, we’re all about ideas. We have all the ideas in order to let you know about all of your options. Which option is best for you? Let’s talk about you and find out!