Employers periodically consider implementing safe-harbor plans to avoid failure of the nondiscrimination tests. This result is desirable, since employers prefer not to return excess contributions that exist upon failure of the actual deferral percentage and actual contribution percentge tests to highly compensated employees. If such actions occur, HCEs are generally unable to achieve their retirement savings goals, which often leads to dissatisfaction.
The traditional safe-harbor profit-sharing contribution is the easiest way to satisfy the nondiscrimination rules. All eligible employees receive a fixed profit-sharing contribution equal to 3% of compensation, which is 100% vested. As a result of this contribution, the ADP/ACP tests aren't required to be satisfied, and the 3% top-heavy contribution is also satisfied for plans where more than 60% of all account balances are attributable to key employees. In order to establish a safe-harbor profit-sharing plan, all employees must receive the contribution, and allocations may not be limited to individuals who work 1,000 hours or are employed on the last day of the calendar year.
Matching contributions
As an alternative, a safe-harbor plan may provide for a 100% vested and fixed matching contribution. The basic safe-harbor matching contribution is 100% of the first 3% of salary deferral contribution, and a 50% matching contribution on deferrals between 3% and 5%. Thus, the maximum matching contribution is 4% of compensation.
An employer may also choose an enhanced matching contribution formula equal to 100% of the first 4% of compensation. The enhanced matching contribution may not increase as the percentage of deferrals increases, and the rate of matching contributions for HCEs may not exceed the rate of matching contributions for nonhighly compensated employees.
The type of safe-harbor matching contribution elected must be described in the annual notice provided to all eligible participants at least 30 to 90 days before the year in which the matching contribution is made, and the plan must include the "safe-harbor" matching contribution provisions.
Safe-harbor matching contributions generally are subject to the same additional rules that apply to safe-harbor profit-sharing plans, except that safe-harbor matching contribution provisions must be in place at the beginning of the year and the conditional notice alternative is not available. In addition, safe-harbor matching contributions may be reduced or suspended under certain circumstances.
In lieu of the above safe-harbor plans requiring 100% vesting, the Pension Protection Act of 2006 established an automatic enrollment safe-harbor plan. Under this provision, a plan is required to have certain automatic employee contributions, which may be changed or waived by participants. Employees are also required to become 100% vested in all matching contributions after two years, rather than the immediate vesting rule that applies to other safe-harbor plans. Employees are required to be automatically enrolled at a level of 3% for the first plan year, 4% in the second plan year of participation, 5% in the third plan year of participation, and 6% in any subsequent plan year of participation. The employer is required to provide matching contributions equal to 100% of the first 1% of deferrals and at least 50% matching contribution on the next 5% of employee salary deferral contributions.
Contributions under the automatic enrollment safe-harbor plan are subject to the withdrawal rules that apply to other safe-harbor contributions. In order to establish this type of safe-harbor plan, participants must receive an annual notice prior to each December 1, and the plan must include the applicable safe-harbor contribution provisions.
In lieu of the above safe-harbor plans, employers may wish to consider a "super" matching contribution. A super matching contribution may be equal to $250 or $500 for new employees or all employees. For example, an employer may provide that each employee hired on or after January 1, 2014 who contributes $50 to the 401(k) plan in the first six months of employment, and/or existing plan participants, will receive, in addition to the regular matching contribution, a $250 matching contribution. This super match may be subject to the regular vesting schedule or can be 100% vested as desired by employers. In many instances employees are playing the lottery for a big payoff. It should be easy to ask employees where they might achieve a 500% return on their money to encourage savings.
Statistics on automatic enrollment show that 85% or more of all employees automatically enrolled in a retirement plan remain in a retirement plan after they become accustomed to having salary deferral contributions. The advantage of the super matching contribution, similar to automatic enrollment, is that most employees who receive the super match may also remain in a 401(k) plan without the need for a safe-harbor plan.
The super match is not the answer for all employees. However, looking at the design of qualified retirement plans, considering reasonable alternatives, including safe-harbor plans and a super match may periodically warrant consideration. Remember, making a profit sharing contribution to a retirement plan, in lieu of salary increases, saves both employer and employee FICA taxes and saves employees immediate income taxes.
Contributing Editor Frank Palmieri, CPA, J.D., LL.M (Taxation) is a partner with the law firm of Palmieri & Eisenberg, with offices in Princeton, N.J. and Alexandria, Va.
