Ask the Experts!
The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.
Question: My client is considering starting a safe harbor 401(k) plan for his small business. What are the 401(k) safe harbor requirements?
Answer: A 401(k) plan is not allowed to discriminate in favor of highly compensated employees. Ordinarily, a 401(k) plan must pass the actual deferral percentage test, which we described here. However, if an employer sets up a safe harbor 401(k) plan, he doesn’t have to worry about the actual deferral percentage testing requirements.
Two conditions must be met to meet the safe harbor requirements. First, all eligible employees must be given a written notice of their rights and obligations under the plan.
Second, the employer must either make matching contributions or nonelective contributions in one of the following three arrangements:
- Basic Matching. The employer makes matching contributions on behalf of each non-highly compensated employee in an amount equal to:
- 100% of the employee’s elective deferral up to 3% of the employee’s compensation; and
- 50% of the employee’s elective deferral between 3% and 5% (i.e. the next 2%) of the employee’s compensation.
Example: Larry earns a $60,000 salary and contributes 10% ($6,000) of his salary to his employer-sponsored 401(k) plan. The employer satisfies the safe harbor if it matches Larry’s first $1,800 of contributions (3% of $60,000) and half of his next $1,200 contribution (2% of $60,000). Therefore, the employer satisfies this safe harbor if it makes a $2,400 matching contribution.
2. Alternative Matching. The employer makes matching contributions on behalf of each non-highly compensated employee in an amount at least equal to what would be required under the basic matching arrangement (above), and the rate of employer matching does not increase as an employee’s rate of elective deferrals increases.
Example: Larry earns a $60,000 salary and contributes 10% of his salary ($6,000) to his employer-sponsored 401(k) plan. The employer has a plan where it matches 100% of employee deferrals up to 4% of the employee’s salary. Therefore, the employer makes a matching contribution equal to $2,400 (4% of $60,000) and satisfies the safe harbor.
3. Nonelective contributions. The employer makes a nonelective contribution for each eligible non-highly compensated employee of at least 3% of the employee’s compensation, regardless of whether or not the employee actually makes an elective deferral.
Example: Larry and Curly both earn $60,000 salaries. Larry contributes 10% of his salary to his employer-sponsored 401(k) plan, but Curly doesn’t contribute anything. The employer satisfies the safe harbor if it makes a $1,800 contribution (3% of $60,000) to both of Larry’s and Curly’s plans.
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