When employers are ready to sponsor a qualified retirement plan, a 401(k) is often the first one that springs to mind. However, many small to midsize organizations may hesitate to leap headlong into a 401(k) because of its inherent administrative complexity.

For example, traditional 401(k)s are subject to annual nondiscrimination testing to ensure that benefits provided under the plan don’t disproportionately favor highly compensated employees over non-highly compensated ones.

But did you know that eligible employers can avoid this hassle by sponsoring a safe harbor 401(k)? Read on for some insights into this intriguing benefits vehicle.

Basic features

A safe harbor 401(k) is a version of the well-known qualified retirement plan that automatically satisfies the nondiscrimination rules because the employer-sponsor agrees to make specified minimum contributions to participants’ accounts. Generally, this means either:

• Matching 100% of employees’ payroll-based contributions (elective deferrals) up to 3% of compensation and then 50% of contributions on the next 2%, or
• Making a nonelective contribution of at least 3% of compensation to all eligible employees, regardless of whether they contribute to their accounts.

The primary advantage of setting up a 401(k) this way is that it exempts your organization from having to annually perform complex nondiscrimination testing, which simplifies plan administration considerably.

Another advantage is safe harbor 401(k)s allow highly compensated employees — typically owners and executives — to max out their personal contributions without worrying about causing the plan to fail nondiscrimination testing. This can happen with traditional 401(k)s.

What’s the catch? Employer contributions are mandatory — and they fully and immediately vest in participants’ accounts. So, regardless of which of the two routes you take, you must have the cash flow to fund those contributions. Generally, once you provide employees with the required “safe harbor notice” in writing, you’re legally committed to making the specified contributions for the plan year.

Top-heavy rules

The nondiscrimination rules focus on yearly contributions to traditional 401(k) plans. Also applicable are so-called “top-heavy” rules, which focus on the overall distribution of plan assets.

According to the IRS, “A defined contribution plan is top-heavy when, as of the last day of the preceding plan year … the aggregate value of the plan accounts of key employees exceeds 60% of the aggregate value of the plan accounts of all employees under the plan.” (Key employees are generally owners or highly compensated “officers” as defined by the IRS.)

So, are safe harbor 401(k)s also exempt from the top-heavy rules? The answer is usually, but not always. A safe harbor 401(k) with only elective deferrals and safe harbor matching contributions is generally exempt from being top-heavy. If the plan is making a nonelective contribution of 3% to all employees, it also automatically satisfies the top-heavy contribution requirement.

However, a safe harbor 401(k) with matching contributions may lose its exemption from the top-heavy rules if:

• The plan allows discretionary nonelective contributions, and one is made,
• Forfeitures are allocated to participants’ accounts in the same manner as nonelective contributions, or
• Employees can make elective deferrals immediately but aren’t eligible for a matching contribution until after they complete one year of service. (This is uncommon.)

Thus, nonexempt safe harbor 401(k) plans can become top-heavy because key employees’ accounts can receive maximum contributions. If a plan becomes top-heavy — and a key employee defers or receives an allocation of a certain percentage — the employer must allocate that percentage to all eligible non-key employees.

Furthermore, if the plan is making a safe harbor matching contribution — and it’s not considered exempt — you’ll need to make extra contributions of the required percentage for eligible employees who aren’t making elective deferrals and for participants who are deferring less than that required percentage.

Bottom line

If your organization decides to sponsor a safe harbor 401(k), it’s critical to carefully design the plan in consultation with the appropriate professional advisors.