With each 401(k) plan, you will have a wide array of options on how you wish to contribute to your employee’s retirement funds. Through some plans, like the Traditional 401(k), the choice to contribute is optional. Under others, such as the Safe Harbor plan, contributions are mandatory, serving as one of the many incentivizing focal points of this retirement plan contribution scheme. For business owners that wish to maximize employee contributions without the burden of annual IRS testing, the Safe Harbor option may be precisely what you need.
Key Traits of the Safe Harbor Plan
Each year, business owners are subjected to three primary testing measures executed by the Internal Revenue Service (IRS). The evaluations ensure that Highly Compensated Employees (HCEs, those earning more than $130,000 annually) and key stakeholders (anyone with more than a 5% stake in the business) are not favored over lower-earning staff.
What does this have to do with the Safe Harbor plan? Employers who opt to integrate Safe Harbor provisions can avoid the hassle of these tests and the tedious administrative tasks that come along with them. How? This plan is determined to be inherently compliant with two of these tests, meaning you will not have to take them at all! (These tests include Actual Deferral Percentage, Actual Contribution Percentage – both of which you bypass – and Top Heavy.)
This leaves room for all your employees to maximize their retirement contributions according to the following matching formulas:
- Basic: On the first 3% of employee contributions, you will match the funds dollar-for-dollar. For 2-5% of subsequent deferrals, you will match an additional 50% of the contributions.
- Enhanced: For the first 4-6% of employee compensation deferrals, you will be required to match their contributions dollar-for-dollar.
- Nonelective: You will match up to 3% of each eligible employee’s gross annual salary. This is required whether they choose to make contributions or not.
Depending on your goals and employees’ needs, you will need to select the contribution scheme that is most beneficial to your company.
Choosing the Appropriate Safe Harbor Contribution for Your Business
The Safe Harbor alternative is ideal for small businesses whose employees tend not to participate in the business’s retirement plan, or whose “key employees” hold at least 60% of the plan’s assets. Additionally, any company that has previously failed nondiscrimination testing will benefit from Safe Harbor provisions. Still, the specific contribution formula that you choose will depend heavily on the specifics of your company.
You can select the appropriate contribution structure (out of those listed above) using the following formula:
- Total # of Employees ×# of Participating Employees (Represented in % of Total Workforce) ×Average Gross Salary ×Chosen Contribution %
You can use this formula to find the amount you will be contributing throughout the 12-month plan period. For example, suppose that your business employs 25 people, each earning about $50,000 annually. Say, about 70% of your workforce participates in the plan. With the Basic plan, you will be required to contribute a minimum of $26,250 (25 x 0.7 x 50,000 x 0.03) with the dollar-for-dollar matching alone, apart from the 50% subsequent contributions.
The choice of which contribution structure is most appropriate for you is highly subjective and depends on your business’s specific traits and financial goals. To determine which option is best for both you and your employees, review your business needs, and consult with a 401(k) plan provider before committing to Safe Harbor provisions.