Mid-year offers opportunity to check in with your 401(k) plan clients to see how their plans fared on mid-year testing. These test results don’t count against the plan in any way, but they are a helpful gauge of whether the plan could fail nondiscrimination testing at year end–when there are consequences for failed testing results.
If some clients are hesitant to commit to the safe harbor design (and the potential increase in employer cost), they don’t have to decide right away. They can wait and see how mid-year testing goes next year before deciding whether they want to adopt a safe harbor 401(k) plan if they follow the rules for the safe harbor maybe notice.
401(k) Plan Nondiscrimination Testing Refresher
In a traditional 401(k) plan, certain nondiscrimination tests must be passed each year to prove the plan is not disproportionately benefiting highly compensated employees (HCEs). These tests include:
- actual deferral percentage (ADP) test, which measures elective deferral rates
- actual contribution percentage (ACP) test, which measures matching contributions and employee after-tax contributions
These tests can limit how much HCEs can defer into the plan or receive as employer matching contributions in situations where plan participation and/or contribution rates for non-HCEs are low. If a plan fails ADP/ACP testing, the plan sponsor must take corrective actions such as returning deferrals to HCEs or making additional employer contributions for non-HCEs. Plan sponsors can guard against failed testing results by adopting a safe harbor 401(k) plan feature.
Safe Harbor 401(k) Plans
If a 401(k) plan meets the requirements to be a safe harbor plan, it is deemed to pass the ADP/ACP tests. The safe harbor requirements include making a mandatory employer contribution, applying 100% vesting, restricting distributions of the mandatory employer contributions, and providing notices to employees.
So long as the plan meets these requirements, the need for ADP/ACP testing is eliminated. Owners and HCEs can contribute the maximum level of elective deferrals without worrying about the contribution rate of the lower-paid employees. Mandatory safe harbor contributions also may satisfy the employer contributions required when a plan is top-heavy.
To satisfy the employer contribution requirement, the plan sponsor must choose one of the two different types of contributions.
- Basic Match: 100% match on elective deferrals that do not exceed 3% of compensation, plus 50% match on elective deferrals that exceed 3% of compensation but do not exceed 5% of compensation, or
- Enhanced Match: variations of the basic match are permitted, subject to requirements outlined in the 401(k) regulations
- 3% of compensation allocated to all eligible employees, regardless of whether they make elective deferrals
The safe harbor feature generally must be adopted before the first day of a plan year and remain in effect for a full 12-month period. Special rules apply if a new plan is being established or the feature is being added to an existing plan that is not a 401(k).
Safe harbor plans must inform employees about the features of the plan and must be provided within a reasonable amount of time before the start of each plan year (30–90 days is deemed reasonable). The timing of this annual notice informs employees whether the plan sponsor’s contribution for the coming year will be conditioned upon the deferrals they make into the plan (matching contribution) or made to all eligible employees, even those who do not defer a portion of their compensation into the plan (nonelective contribution).
Safe Harbor 401(k) “Maybe” Notice
If a plan sponsor is unsure whether they want to commit to the funding expense of a mandatory contribution, they may take advantage of the safe harbor maybe notice. If they provide this notice to employees before the start of the plan year, they may wait until quite late into that plan year to decide whether to operate as a safe harbor plan and provide the mandatory contribution. A maybe notice can be beneficial when a plan sponsor has failed the ADP/ACP tests in prior years or experienced recent changes to its employee population that could affect the ADP/ACP tests in the coming year.
There are four potential steps in the wait-and-see method.
- Initial Notice: The plan sponsor must notify eligible employees 30–90 days before the beginning of the year that it may or may not operate as a safe harbor 401(k) plan in the coming year, and that if it does, a 3% nonelective contribution will be made for all eligible employees in the coming year.
- Supplemental Notice: If the plan sponsor chooses to operate as a safe harbor plan, the plan sponsor must provide a follow-up notice to the eligible employees about the 3% nonelective contribution and the safe harbor status of the plan.
- Plan Amendment: The plan document must be amended at least 30 days before the end of the plan year.
- Contribution: The plan sponsor must fund the 3% nonelective contribution.
If the plan sponsor decides not to operate as a safe harbor plan, no document amendment, employee supplemental notice or contribution is necessary. The ADP/ACP tests must be performed using current-year data.
Proposed Changes Would Make the Maybe Notice Even Easier to Use
Congress is currently reviewing two separate retirement savings-related proposals that include changes to the safe harbor 401(k) rules. These proposals would make it easier for plan sponsors to take this wait-and-see approach. The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019
would eliminate the employee notice requirement so long as employees are still allowed to make or change their deferral elections at least once per year. The SECURE Act would also extend the deadline to become a safe harbor plan to the last day for distributing excess contributions for the plan year (generally, by the close of following plan year) if the plan provides for at least a 4% nonelective contribution for all eligible employees for that plan year. The Retirement Enhancement and Savings Act (RESA) of 2019 contains similar provisions. Because of the similarity of the House and Senate bills and the bipartisan support that’s been shown so far, industry experts agree there is a good chance one of these bills could pass during this Congress.
Advisor Action Steps
- Identify safe harbor 401(k) plan prospects: Existing plans with failed ADP/ACP tests are not the only candidates for a safe harbor plan. Businesses with fluctuating profits, high turnover, or a significant group of employees earning a relatively low wage are also candidates for a safe harbor 401(k) plan and the wait-and-see approach of the maybe notice.
- Educate prospects about safe harbor plans: Educate plan sponsors about the safe harbor plan design options that can bypass certain testing requirements and allow HCEs to increase their plan contributions.
- Introduce plan design experts: Help plan sponsors work with plan design experts to create projections that illustrate the potential costs of the various options for safe harbor contributions.
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Newport Group and its affiliates do not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before making any decisions.