This is a time of year where 401(k) plans are required to issue refund checks to their highly compensated employees if the plan failed the annual compliance testing. These checks are called corrective distributions and the deadline to issue them is March 15 every year. To put it simply, if the testing reveals that the plan benefits are highly skewed towards the employees that are considered highly compensated employees (compensation in excess of $130k), then a corrective distribution is required. We won’t get into the weeds of the calculations and instead will offer a few ideas on how to reduce or even prevent these distributions. This part will cover safe harbor plans.
While safe harbor effectively eliminates the discrimination tests that lead to the refunds, it requires some fairly significant contributions from the employer. The two most common safe harbor contributions are non-elective and safe harbor match. With non-elective, the employer simply agrees to contribute 3% to all eligible employees regardless of whether they contribute or not. In a safe harbor match, the employer only has to contribute for employees that are participating in the plan. However, the employer could potentially end up having to contribute more to the plan if all eligible employees participate. The match formula requires the employer to match 100% of the first 3% that employees contribute and 50% of the next 2% they contribute for a total employer contribution of 4%. Therefore, employees would have to contribute 5% to receive the full 4% from the employer.
Another item to note with safe harbor is vesting. The employer contribution is fully vested immediately vs. regular employer contributions that can be subject to vesting schedules up to 6 years. That can be an item of concern for high turnover companies. Eligibility for the contributions follows eligibility for the plan. Therefore, if an employee is eligible to participate in the plan, then the employer is required to make safe harbor contributions for that employee. Eligibility can be set anywhere from immediate eligibility up to one year.
There is a lot more to think about with safe harbor than what is outlined here, but these are the major considerations. While we acknowledge that this option could add costs to the employer in match dollars, it is your duty as a fiduciary to the plan to explore different options to improve your plan. If it sounds like it could make sense for your company, we recommend reaching out to us or consulting with your plan professionals to discuss in further detail. Next week, we will cover some options that don’t come with the full avoidance that safe harbor offers. However, they are viable options to consider and are generally more cost effective.